Risk Management G Insurance

Risk Management in General Insurance
1.1 INTRODUCTION
Risk management as a subject and as a function function of businss management and

therefore the purpose of unit is to explore some of the basic concept of risk and
management of it.
The Entrance Arch into Lords where the World Cup 1999 culminated, carries the
following inscription, excerpted from the Poem "IF" of Rudyard Kipling, "If you
can cope equally well with triumph and disaster, JOU Will probably do all right
for yourself. Apparently, Kipling was writing about large and enduring things but
his sentiments very emphatically can be applied to any modern commercial enterprise
(including that Great Commercial Enterprise of International Cricket). In a real sense,
Business process is as much about coping with problems as it is do with Sales
Performance and Bottom line. This continuous process of problem solving, like any
other Faculty of Management, is an Art as well as a Science. This presentation aims
to identify a few critical areas of the "Risk Management Function". For the purpose
of ease in comprehension, this write up would use the word "Risk" as interchangeable
with "Hazard" (though essentially, Hazard is the cause and Risk is the resultant).
i,
The term Risk Management first appeared in print in the Harward Business Review in an
article by Russel Galigar in 1956, although this term has been in conversational use some
years before. Ever since insurance was transacted as a separate discipline, the term Risk
Management has been interchangeably used with insurance. The word risk has shades of
uncertainty. In common parlance the word risk has been used more to indicate the chances
of failure. Life in this planet has evolved around a lot of uncertainty. Ever since life on this
planet evolved from the amoeba stage to the current level of human race, there have
always been uncertainties in the environment for billions of years. It was through a process
of mutation one species evolved into another, thereby overcoming the risks of uncertain
destinies. As we will see in the later chapters, Risk and Uncertainty have a direct relationship.
But then both are still different.
1.2 NECESSITY OF RISK MANAGEMENT

We all are familiar with resources that have many forms - Men, Materials, Finance, and
Intellectual Property etc. All of us are also aware that the human life involves a large level
of dynamism. Whether one chooses to call it as progress or deterioration, human life has
moved from one phase to another.
In the 20th century we have seen Industrial Revolution emerge into Technological Revolution
and in the 21 st century we are seeing even Basic Sciences undergoing tremendous amount
Unit 1
Basic Concept of Risk Management
of change in their approach and focus. But the problem with resources is that they are
limited in quality and quantity, e.g., Fossil fuels like Petrol, Diesel. Though reserves of
these types of fuels are being discovered from time to time, the fact remains that they are
all depletable. So, we have a situation, where there are several opportunities, these
opportunities require resources, but there are limitations in terms of the quantity and quality
of resources. So, we are forced to choose between the various opportunities and allocate
the limited resources in such a way that the optimum benefit from such an opportunity can
be derived.
Risk Management is all about efficient allocation of resources to various risks so that an
optimum utilization of these resources takes place.
When we talk of optimum utilization of resources, this process is not confined only to
Business Organizations. Even in individual life we come across several opportunities and
we similarly face the resource crunch which organizations face. We are therefore forced to
allocate priorities and use our personal limited resources in the best possible manner. Not
only commercial organizations but also Non-Profit entities like hospitals, charitable institutions
and even Government Departments will have to undertake the process of Risk Management
for efficient use of resources. So long as there is a limitation on resources and so long as
there is a variety of options available for using these resources then there has to be a
process of Risk Management.
JJ&Activity A:
Comment on "Risk Management is necessary for efficient use of resources."
1.3 IMPORTANCE OF RISK MANAGEMENT

Risk creates anxieties and anxieties result in lesser than efficient utilization of resources.
Risk Management enables a business to handle its ordinary businesses in a better manner.
Freed of concern about both accidental losses as well as usual business risks, a business
can more aggressively and intelligently organise its regular activities. Whether it is introduction
of new product or extending the operation into a new territory or making investments to
expand the level of operations, all will hinge upon the perceptions of risk both of accidental
and regular nature. The increasing complexity of both business and personal life Risk
Management is no longer an option.
Think of the number of Non-Banking Financial Institutions that suffered a collapse in our
own country. Many of them had a fundamental deficiency in that; they did not manage their
risks of their investments properly, with a result many investments floundered. Similarly,
think of several Fortune 500 companies in the United States of America collapsing one
after another in recent weeks. These companies again had a fundamental flaw that the
Corporate Management was less efficient in the management of risks related to Corporate
Governance.
Âctivity B :
You are a Director of a drug manufacturing factory and want to appoint a risk manager.
Write down your views on "Responsibility of a risk manager" in your factory.
1.4 DEFINITION OF RISK

Risk is defined in various ways, in various contexts. This write-up will define Risk as
Williams & Heins chose to define: "the variation in the outcomes that could occur
over a specified period in the given situation."
If only one outcome is possible, the risk is Zero. The greater the variation, the greater the
risk.
A risk may be defined as follows:
Risk is the possibility of an unfortunate occurrence.
Risk is a combination of hazard.
Risk is unpredictability _ the tendency that actual results may differ from predicted
results.
Risk is uncertainty of loss.
Risk is the possibility of loss.
Unit 1
Risk and probability are closely linked. The probability associated with a certain outcome
is the relative likelihood that the outcome will occur. Probability varies between Zero and
One. If the probability is Zero, the outcome will not occur. If the probability is One that
outcome will occur. Since we have defined risk as a function of outcome, mathematically
risk can be visualized as the characteristics of the probability distribution of certain outcome.
Management of risk
In the case of an individual, it is simple that either the individual person or his family organises
the process of Risk Management either in a deliberate or a routine manner.
But in the case of Corporate, the recent trend has been that an exclusive Risk Management
position is created and the Risk Manager handles the process of Risk Management. But,
as you will see in the one of the later chapters, Risk Management need not be isolated or
become insular. Since Risk pervades throughout the organisation, Risk Management also
has to pervade equally well.
1.5 RISK, PROBABILITY AND UNCERTAINTY

Since Risk Management is about managing risks, we need to know clearly, the meaning of
the term Risk. This would again require clarity on meaning of associated terms like Probability
and Uncertainty.
We will first start with the definition of the concept of Probability. The probability associated
with a certain outcome is the relative likelihood that the outcome will occur. Before the
start of a Cricket match we have all seen the rival captains marching out to the centre of the
field and one of them tossing the coin and the other calling either Head or Tail. There are
two possible outcomes - Head or Tail and therefore the possibility that one of the outcomes
will occur during the toss of a coin is one by two. Contrast this with the possibilities, which
emerge out of a single ball being bowled. There are a variety of possibilities for such a ball
being bowled - It could be a run out, it could be a hit wicket, it could be a stumping, it
could be a clean-bowled etc. Therefore the probability that out of a ball being bowled the
result will be run out is certainly not one by two or one by six but it is far less than that.
Probability varies between zero and one.
If the probability is zero, a particular outcome will not occur at all. If the probability is one
then that outcome will certainly occur. The closer the probability is to one the more likely
it will occur. If one starts plotting the probability of various outcomes out of a particular
event along a graph, then one gets what is called as the Probability Distribution.
Please see the illustration Figure 1.1 and 1.2 wherein two probability distributions are
given. You will find that the possibilities in the probability distribution 1.1 are more when
compared to the possibilities given in the Figure 1.2. These illustrations will be useful in
understanding the concept of risk which we will define subsequently.
1
Probability
100
200
300
400
500 (Rs. Crores)
Fig 1 : Total Losses in a financial year
Probability
100
200
300
400
500 (Rs. Crores)
Fig 2 : Total Losses in a financial year
Unit 1
ire en
Take the case of a factory manufacturing electric bulbs. For every thousand bulbs, the
probability that there will be zero defects will have a number attached to it. Similarly, the
probability that for every thousand bulbs, hundred bulbs will be defective will also have a
certain number attachable.
Likewise, the probability the elevator in a high rise building consisting of 40 storeys will
always reach the desired floor or any particular floor also will have a certain number
attachable to it. Perhaps if it is a good elevator system, almost close to one. On the other
hand the probability that your boss is going to be good to you in office on any particular
day cannot have a clear number attached to it. Similarly the probability that the stock
market index will reach a particular level on a particular day cannot also have a clear
number attached to it.
The reason being the former type of examples like the manufacture of electric bulbs or lift
reaching a particular floor has what is called as an underlying probability to it and this
underlying probability is more often than not an objective probability. By objective we
mean that there is statistical evidence which may be available or which can be established
through which this objective probability can be figured out.
All the examples given the probability can be estimated by computing the proportion of
times the outcome in question occurs in a long series of repeated observations, e.g. for
computing the probability of a certain number of bulbs being defective we can repeat the
observations for a period of lets say 100 days or so and then whatever probability emerges
out of that or whatever proportion emerges out of that these series of observations can be
close to the underlying objective probability.
There is a theorem called as the Law of Large Numbers which may be proved mathematically
and which goes as follows "As the number of independent observations increases the
proportion of times as certain outcome occurs tends to approach the underlying probability".
That this statement is subject to the assumption that if the underlying conditions undergo a
change then still statistical evidence may be available that would indicate the trends, cycles
or seasonal fluctuations that will affect the outcome. For e.g. The probability that the 'Hole
in One' situation will happen in a golf course may undergo a change if the landscape of the
golf course is drastically altered. What is to be remembered however is that if you go on
(MgppBi^)fccv7X under essentially the same CQMitiQ^â\^Q\vw&feiw Osss&vo^t
/ing objective probability.
As there exists objective probability, there is also a possibility of probability being estimated
subjectively - because there was lack of any statistical history. You have seen it happen in
the film making industry. The chances that a particular film starring, let us say, even a very
popular hero like Shah Rukh Khan, will be a box office hit, cannot be very statistically
established and therefore it has to be a highly subjective estimate - Though academicians
will dismiss subjective probability as more of a belief. Subjective probability has always
been utilized gainfully in human endeavors.
Think of Leonardo da Vinci who was trying to simulate the flight path of birds - all he was
doing was to estimate probabilistic the chances of successful flying so long as the flight
mechanism of birds was copied. But it took several centuries for the Wright Brothers,
actually to bring this concept into reality. Therefore, subjective probabilities have always
had lent inner strength to creative talents of mankind.
Uncertainty is a person's conscious awareness of the risk in a given situation. It

depends upon the person's estimation of the risk that is what the person believes to be the
state of the world and the confidence he or she has, in this belief. We could say that the
concept of uncertainty implies doubt about the future based on a lack of knowledge, or
imperfect knowledge. Therefore the concept of uncertainty is close to what one can say as
the subjective estimation of the risk, and naturally any commonly accepted yardsticks
cannot measure uncertainty.
s
Now, we will get to define the crucial concept namely Risk. The Oxford English Dictionary
defines Risk as "Chance of danger, injury, loss", etc. The same dictionary defines Risk as a
verb as "exposed to risk, venture on, takes chances of". There have been other definitions
of risk. Risk has been defined as "subject of insurance, uncertainty concerning the outcome"
etc. We have to be clear that risk does not necessarily have a negative implication. We will
see more of this later, but for the current purpose, Risk will be defined as the variation
in outcomes that could occur over a specific period of time, in a given situation. If
only one outcome is possible the variation is zero and therefore the risk is zero. If many
outcomes are possible the variation is greater and therefore the risk is greater. The greater
the variation, the greater the risk. Since we call these graphics as probability distributions
it is to be understood that Risk is a characteristic of the probability distribution.
You can readily understand the concept of risk if you go back to the example given earlier
of the coin tossing before the cricket match and the possibilities, which can arise out of a
single ball being bowled.
The Risk in coin tossing is less as variations are only two. But, in every ball, the Risk for
batsman or even bowler is more, as variations are more.
Unit 1
Âctivity C :
What is a difference between risk and uncertainty?
1.6 CLASSIFICATION OF RISKS

There are various ways to categories risk. One thing is certain that almost all human activities
involve some risk and some uncertainty. In a Metropolitan city like Mumbai, even leaving
the home and returning home safely is an activity which carries a sizeable amount of risk.
As individuals, as Organizations, we face as [variety of risks. We will first look at a broad
categorization of risks.
Pure Verses Speculative Risks
Pure Risk is where there is a chance of a loss but there is no chance of a gain. This means
that if the event associated with the risk does happen, there is only a chance that there will
be a financial or personal or social or economic loss and no gain whatsoever.
Think of a travel in a boat across the river - If the boat capsizes, there can be only loss of
life or loss of property. Here the event, which carries the risk, is the boat travel. The
outcome which can happen out of this travel is a possible capsizing or safe landing on the
other shore. So the contingency called the capsizing of the boat really comes about, then
there is obviously no gain. Compare this with the film making.
Speculative risk is a type of risk where there is a possibility of either gain or a loss occurring
out of an event. A film well made with the right script and right cast can succeed or can
flop.
To get this clear, let us once again examine the variations which can arise out of traveling in
a boat across the river. One possibility is that you will reach the other shore safely. Other
possibility is that the boat may drift and take you to another location. The third possibility
is that there is a weather storm or high currents in the river, which will make the boat
capsize.
If you look at only these three possibilities or possible outcome then there is associated
probability of each of these events. For e.g. for every 100 trips made across a particular
river in a particular type of boat the probability that the boat may capsize may be one in
hundred, and the probability that the boat might drift may be 5 in hundred and the balance
94 out of hundred is the probability that the boat will take you across safely. It is not to be
understood that just because the probability of capsizing is .01 or one in hundred the risk
is low. Actually the risk is low in this travel scenario only because there are just 3 possible
outcomes.
As against this going back to the example of the outcome that can arise out of a cricket ball
being bowled there are so many variations possible. Though each of them might have a
high or low probability associated with it, just because the variety is huge, the risk is huge.
Coming back to Pure Risk in the boat travel, the event that the boat could capsize represents
a pure risk situation. If the boat capsizes there is only a loss of life or loss of property and
therefore a loss situation.
In contrast to this investment in share markets represents a speculative risk situation. A
stock can appreciate or depreciate depending upon various factors and therefore an investor
can either gain on its holdings or lose on its holdings.
Pure risks also differ from Speculative risk situations in that they are generally repeatable
and have essentially the same outcome under the same conditions and are therefore more
amenable to the Law of Large Numbers. Except in a game of chance wherein again due to
repetition the Law of Large Numbers is still applicable and one can estimate e.g. in how
many throws one could get the number six in a dice.
Examples of pure risks are fire at a factory, storm, accidental death or injury at work and
theft of goods from a store. The various business risks cited are all speculative risks. Most
pure risks can be dealt with by insurance, but speculative risks are generally uninsurable.
Another difference is that most pure risk situations result in loss and if an individual looses
the society also loses. As you know, if there is a major catastrophe like in an Earthquake
or Flood Storms, all individual loses sum up to huge loses for the society or country as a
whole. The only exception perhaps is where an individual looses his possessions by the
way of an act of theft or burglary and this mans loss results in gain to another individual
who has taken possession of it.
Another interesting aspect about Pure and Speculative risk is that both may coexist. To
illustrate, think of an individual's holdings in gold. Gold is subject to burglary or theft and
Unit
this represents the Pure Risk situation whereas gold is also subject to price fluctuations both
upwards and downwards and this represents the Speculative Risk aspect.
Âctivity D :
Write down four examples each of pure and speculative risks.
1.6.2 Dynamic Versus Static Risks

Dynamic risks arises from the changes that take place in every society, that is, economic,
social, technological, environmental and political changes. The static risks are those that
would exist in the absence of such changes.
Change in price level, consumer tastes, income and outgo, financial loss due to change in
technology are some examples of Dynamic risks. These risks are less predictable.
In static risks involves destructions of asset and hence loss to the individual and ultimately to
the society. Generally these risks are predictable.
Dynamic risks are closely related to the speculative risks whereas most pure risks are also
examples of static risks.
Static risks are insurable where as Dynamic risks are not insurable.
Âctivity E:
Write few words on "Dynamic risks may affect a large number of individuals ".
1.6.3 Fundamental Versus Particular Risks

Fundamental risks are those which arise from causes outside the control of any one individual
or even a group of individuals and affect the whole of society or a major part thereof, such
as uncertainties arising out of the economic or political system or natural catastrophes such
as earthquake, flood, famine, volcano and other natural disasters. They are both impersonal
in cause and effect.
Particular risks are much more personal both in their cause and effect and affect mainly the
individual or firm and arise from factors over which he may exert some control such as fire,
theft, work related injury robbery in bank and motor accidents.
It may be argued that society collectively should accept responsibility for the losses incurred
by individuals arising from fundamental risks, whereas individual should make their own
arrangements for dealing with particular risks.
Over time, views change as to the division between fundamental and particular risks. For
example, in the past unemployment was regarded as a matter of individual responsibility,
but is now universally recognized as a responsibility of government. v
$ Activity F;
'Fundamental and speculative risks are usually uninsurable.' Explain whether this is a true
statement.
1.7 CLASSIFICATION BY SIZE OF LOSS

A classification of risk can also be done according to potential loss severity for the individual
or firm exposed to loss, as follows:
Class I - Those losses which do not disturb a firm's basic finances.
Class n - Those losses which would necessitate rising additional finance by borrowing or
a share issue.
Unit
Class III - Larger losses which might bankrupt the firm.

Where as it may be possible for a firm to handle internally Class I and even
Class II risks, normally Class III losses can only be handled by transferring
them,
usuall
y to an
insurer
.
Â ct ivi ty G :
"Young drivers pay higher premiums than other drivers even if the car insured is
a smaller one." How would you explain this?
1.8 OTHER TYPES OF RISKS

Other than the above-mentioned categorization there are also many other ways
in which risks are specified or categorized.
Production Risk: A firm may fail to produce its planned output at a planned unit
cost due to the operation of many types of uncertain events, or a change in
market conditions may adversely affect the availability and /or cost of materials
and parts its purchases.
The Marketing and Distribution Risks : A firm must be able to sell all its
products at a planned price deliver it to its customers. But due to change in
fashion, general economic conditions, introduce better product by competitors
etc it may fail to do so.
Financial Risks: If the earning falls due to increase in rate of interest of bank
finance or change in exchange control regulations, change in credit facilities
offered by financers, failure of debtors etc results in financial loss.
Personnel Risks : The success or failure of any enterprises depends on the
ability , integrity and enthusiasm of its directors, managers and employers
.Loss of a key man due to injury, sickness or death may disturb the future
planning of a company or poor industrial relations lead to frequent stoppages of
work.
Environmental Risks : Due to increase in awareness of pollution due to
disposal of industrial wastage on land and into water courses or release of
contamination into air, industrial firms may run the risks of heavy fines due to
violation of pollution laws.
13
All organizations have an inherent risk but the types of inherent risk vary depending upon
the type of organisation. For e.g., a manufacturing unit has a larger exposure to occurrences
like Fire and explosion, whereas a financial institution has lesser exposures in respect of
these kind of contingencies. On the other hand the latter is substantially exposed to a risk
of speculative nature.
Contingent Risks: where events and circumstances beyond the control of an organisation
dictate these type of risks for e.g. the market forces, the customers profile getting
affected - all these are contingent risks.
Customer Risk: Dependency on a certain type of customers creates vulnerability because
if the customer preference shifts, then the supplying organisation suffers directly.
We have also the Fiscal or Regulatory Risk. Similarly Suppliers Risk which used to
involve only evaluation of the ability of the suppliers to ensure supplies on minimum standard
is now even expanding beyond such considerations to concepts such as suppliers
compliance's regarding Environmental considerations.
In a project development situation, both the promoters and lenders of the^ project carry an
enormous amount of and variety of risks, which ultimately they try to balance by retaining
and transferring such risks to various participants in the project situations, and this is what
results in a number of project agreements. Similarly, the financial institutions carry the risk
of lending, non-performing assets, interest rate risk, swap risk, currency risk" etc.
Political changes can bring more government intervention in employment, marketing,
investment and other policies may lead nationalization without compensation.
Organisations and individuals also carry what is called as Reputation Risk which may arise
out of considerations like errors and omissions, defamation, professional malpractice etc.
Another new and unsettling source of risk is political risk. We have seen the effects of
September 11 and we have also seen the build up of tensions along the Indo-Pakistan
border and the consequent Travel Advisories issued by many developed countries.
An on-going organization encounters a continuous spectrum of risks. This risk could be
either internal or external to the organisation, this risk could be one of those which are
controllable by the organizations Management or those which are beyond.
Risk need not always have a negative halo. The famous American educationist John
Gardner, once said, "Problems are all brilliantly disguised opportunities". The same
way risk can also induce positive developments. The risk of being left behind by competitors
Unit 1
indeed compels many organisations to stretch themselves to the limits of creativity and be
constantly innovative.
Âctivity H:
A food Manufacturer has a large factory with sophisticated machinery and production
lines. He produces a range of foodstuffs for both home and export market. List out risks
faced by this factory.
1.9 TYPES OF RISKS REQUIRED TO BE MANAGED

Any professional Risk Manager in a business organisation would be concerned about
Pure risks. He or she will be involved with Speculative risk situations only to the extent that
the creation of Speculative risk, forces them to face certain Pure risk. For instance, the
acquisition of a new property by a business enterprise represents both Speculative and
Pure risks. The Speculative risk is created by the possibility that this investment may result
in either financial gain or financial loss to the organisation. Whereas, a typical Pure risk is
represented in such newly acquired property by the possibility that it may undergo a loss
due to fire or cyclone.
Âctivity I:
"Nowaday it is felt that Fundamental risks are responsibilities of the society." How would
you explain this?
ts of
conce
constantly innovative.
rned
about
jgÂctivity H:
Pure
A food Manufacturer has a large factory with sophisticated machinery and risks.
production lines. He produces a range of foodstuffs for both home and export He or
she
market. List out risks faced by this factory.
will be
involv
ed
with
Specul
ative
risk
situati
1.9 TYPES OF RISKS REQUIRED TO BE MANAGED____________________
ons
Any professional Risk Manager in a business organisation would be only
to the extent that the creation of Speculative risk, forces them to face certain
Pure risk. For instance, the acquisition of a new property by a business
enterprise represents both Speculative and Pure risks. The Speculative risk is
created by the possibility that this investment may result in either financial gain
or financial loss to the organisation. Whereas, a typical Pure risk is represented
in such newly acquired property by the possibility that it may undergo a loss
due to fire or cyclone.
Âctivity I;
"Nowaday it is felt that Fundamental risks are responsibilities of the society."
How would you explain this?
15
1.10 SUMMARY
In this unit we have introduced the concept of Risk and Uncertainty. The occurrence of
some events may result in either gain or loss whereas others cause only loss. Some events
are the results of human behaviors, others are beyond human control. Fundamental risks
are normally so uncontrollable, widespread and indiscriminate that it is felt they should be
the responsibility of society as a whole.
In this unit we also discussed various types of risks which an individual or organization
have to face in their day to day life and working. We have also seen the impact of various
risks on firms, industries and organizations.
1.11 KEY WORDS
Risk Management
A scientific approach to the problem of dealing with the pure

risks facing an individual or an organization in which insurance
is viewed as simply one of several approaches for dealing
with such risks.
v
Probability
The probability associated with a certain outcome is the relative

likelihood that the outcome will occur.
Uncertainty
It is the conscious awareness of the risk in a given situation.
Risk
It is the variation in the outcome that could over a specific

period of time in a given situation.
Pure Risk
Pure risk is where there is a chance of a loss but there is no

gain.
Speculative Risk
is where there is a chance of gain.
Dynamic Risks
arises due to.economic, social, political, environmental and

technological changes.
Static Risks
are exists in the absence of such changes.
Fundamental Risks
are those which arise from causes outside the control of any
individual or group.
Particular Risks
are much more personal both in cause and effect.
2.1 INTRODUCTION
Imagine for a moment, if the cave man did not step out of confines of the cave, all of us
would still be cave men or women. There is a compulsive characteristic present in the
human race, which makes us venture out and explore. Activities are inherent in all walks of
human life. Human curiosity about the world and environment about us has led to the
development of various bodies of knowledge and various endeavors. As the great German
thinker Nietsche once said "A heart full of courage and cheerfulness needs a little danger
from time to time or the world gets unbearable". So, this takes us back to the question
why should we try to manage risk. The reason is, that risk and its associated levels of
uncertainty, all have an economic cost..
Allan H. Willet, in his discussion of the Economics of insurance refers to the cost of
uncertainty. According to him, the cost of uncertainty arises out of: 1. The unexpected
losses that do occur. 2. The cost of uncertainty itself.
2.2 RISK HANDLING COST
Some cost will be incurred to identify, evaluate and handle risks. Insurance premium,
charges for loss prevention devices are some examples, hi addition there will be opportunity
cost too, time spent on risk handling by management cannot be devoted to other activities.
Loss producing events results in both direct and indirect losses. Suddenly heavy rains in
Maharshtra,Gujrath and Rajsthan causes heavy losses to individual and society directly
and indirectly. We will now discuss it in detail.
2.3 THE COSTS OF UNEXPECTED (DIRECT) LOSSES
Everyday, individuals, businesses and societies suffer losses on account of Pure risk
situations. We see individuals losing their life or getting disabled in road accidents. Similarly,
take the case of the disastrous floods, which hit parts of Germany and Czechoslovakia
recently. Millions of small and medium business have been forced to close because the
raw materials and finished goods which these businesses were storing were either washed
away in the floods or made unfit for sale. The direct cost to a firm due to compensation of
a injured person, loss of production due to accident.
Tsumani taking more than 150000 lives and rendering few thousands homeless and injured.
The terrorist act of 11th September, 2001 in USA which devastated the entire world.
Unit 2
The Process of Risk Management
In most of these cases, the losses, were unexpected either to the individual or to the firm or
to the society and these losses resulted in irretrievable loss of the assets to the society. If
there is any way to either foresee these losses or if they are unforeseeable, manage the
losses once they happen, then there will be tremendous incentive for individuals in business
to continue in their respective activities.
^gTActivity A:
Write down any incidence in which society and individual suffers direct and indirect losses.
2.4 COST OF UNCERTAINTY ITSELF (INDIRECT LOSSES)________________

Uncertainty causes physical and mental strain resulting in fear and worry, therefore such
strain results in lesser creativity and lesser efficiency. Many studies have established that
different people as also different organisations have different levels of sensitivity to risk.
We have to think of those early day Adventure Travelers like Vasco da Garna, who ventured
out against all odds into unknown territories.
These types of individuals have a good appetite for risk and as we have seen in History
subsequently, these adventures have indeed opened up new avenues. Likewise, in the
current day business environment, we find quite a few enterprises going beyond their
routine to explore new and unknown territories of business. After all, all entrepreneurship
is about risk taking. The story of Dhirubhai Ambani is a revelation as to how a risk taking
individual with limited resources could build up a huge industrial empire.
Uncertainty itself has a cost. Uncertainty results in distorted use of resources. Between
two options - one with lesser level of uncertainty and other with greater level of uncertainty,
any individual or enterprise would choose to invest their resources in the first opportunity
rather than in the second. Sometimes this may result in lopsided use of resources. If only
safe avenues of investment were to be chosen, the development as we see today would
have never taken place. Space Technology is a classic avenue which is full of unknowns.
If the level of uncertainty could prevent exploring space, various benefits of such space
technology would not have been available to us at all. From out of the materials, which are
used for spacecraft, today we have novel uses for such materials for even equipments for
disabled persons and synthetic Cornea for people with disabled eyesight.
So if there is uncertainty, people and firms will either avoid any activity in those areas or,
will divert their resources to activities with lesser levels of uncertainty. It has to be
remembered here that when we say uncertainty, it is all perceived and not objective and
hence in this process of either holding back activities or diverting activities we would have
never progressed the way we have today.
^ Ac tiv it y B :
Comment on "If we avoid the risk, we lose the benefits accompanying it."
2.5 PRIVATE AND SOCIAL COSTS

^,
Private costs are those costs necessarily incurred by the individual or firm engaging in a
particular activity.
Social cost is the cost flowing from these activities fall on the community at large.
Cost of raw materials, labour etc. are private cost of a manufacturing company.
Whereas smoke into air, untreated effluents into adjacent water courses or additional
cleaning charges fall on the community.
Both private and social costs associated with many pure risks. A serious fire may close
down a factory with a loss of employment who worked there and also its suppliers and
retailers.
Therefore, we can conclude that uncertainty has a cost and therefore it results in a reduction
in well being because of fear and worry and also less than optimum production or price
levels or price structures. Because Pure risks present no offsetting benefits, individuals,
families and businesses have strong reasons to manage these risks successfully.
Unit 2
Âctivity C:
Suppose there is a PAPER factory in your area. Give your suggestions to control pollutions
and thus private as well social cost should be minimum.
2.6 THE RISK MANAGEMENT PROCESS______________________________

Risks and uncertainty has its economical costs. Human life is full of risks. Without risks
nobody can progress.
Risk Management function includes
Planning
Implementation
Control
for the protection of economic value of assets and earnings of any organization against
adverse effects of risks.
Risk Management is the identification measurement and treatment of Pure risk exposures
in Property, Liability and Personal areas. This process involves five steps.
Identify all significant risks
Evaluate potential frequency and severity of losses
Develop and select methods for managing risks
Implement risk management methods chosen
Control on the performance
Stepl
Risk Identification
This is first and perhaps the most difficult function. The loss exposures of either the business
or family must be currently identified. Risk identification is as on-going process depending
upon the nature of activities, the process or manner of execution.
Failure to identify all the exposures of the firm or family means that the Risk Manager will
have no opportunity to deal with these unknown exposures intelligently.
For identification following aspects must be considered: 1
. Nature, place, process of the activity performed
2.
Political background
3.
Physical, social and legal environment
4.
Study of past records etc.
Example : Risk is depends on type of construction of a building, Location of the

property, surrounding environment production method employed. D :
Corporation has given permission to a CRACKER factory in a residential area .Identify
risk involved in this situation.
Step 2
Evaluate Potential Frequency and Severity of Losses
The next important step is a proper measurement of the losses associated with the exposures
identified. Risk Measurement would include a determination of.
a)
The probability or chance that the losses will occur.
b)
The impact, the losses would have upon the financial status of the firm or the family,
if at all they occur.
c)
The ability to predict the losses that will actually occur over a particular period of
time.
The measurement process helps in grading of exposures from the most serious to the most
irrelevant as well as from the most urgent to the least urgent.
Unit 2
Âctivity E;
How would you evaluate exposures of a gas dealer and a retailer of a sugar.
Step 3
Develop and Select Methods for Managing Risks
Treatment of the Risk
Once the exposures have been identified and measured, the various tools of Risk
Management should be considered and the decision made with respect to the best
combination of tools to be used for treating the exposures. This stage of Risk Management
involves use of tools which primarily aim at a)
Avoiding the risk.
b)
Reducing the chance that the loss will occur or reducing the magnitude of the loss if it
does occur.
c)
Transferring the risk to a Third Party.
d)
Retaining or bearing the risk internally.
The alternative (c) includes but is not limited to the use of insurance. In selecting an
appropriate tool, the cost and other consequences of using such tools or combination'of
tools will be evaluated.
Âctivity F;
"Insurance is the best remedy to transfer a risk." Write down your views.
Step 4
Implementation Risk Management Methods Chosen
Once a decision on treatment of risk is made then comes the question of implementation of
such decision. This may be happening in the form of either purchase of insurance or
transferring the risk to capital market etc.
StepS
Control on the Performance
All Management decisions do have a critical element of monitoring, reviewing the decisions
made, the implementation status and then the results. So that, during the process of
implementation if there is a need to correct the course then it can be done at the appropriate
time. It has to be remembered that individuals as well as organizations do not work in
isolation they are ultimately elements in an environment and therefore there has to be a
continuous process of monitoring how they are related to the environment and change any
objectives or action plans depending upon the changes in the environment.
2.7 THE BENEFITS OF RISK MANAGEMENT
Risk Management makes five types of contribution to the betterment of a business.
a.
Risk Management may make a difference between survival and failure. As you have
seen earlier, a major catastrophic loss like floods can lead to a total halt of business
processes, and the business may run into a Bankruptcy situation. By managing such
risks properly the business can ensure continuity even in the case of such a loss.
b.
Risk Management can contribute dkectly to business profits by helping an organization

to lower expenses through preventing or reducing accidental losses or transferring
serious losses to others at lower transfer fees and through electing to retain risk and
thereby saving a transfer fee. Risk Management helps to improve the bottom line \
imagine if a serious loss is uninsured and there is no recovery possible from an insurance \
firm, then the business enterprise has to carry this loss in its own books and therefore ]
it may become uncompetitive as far as its product pricing is concerned. By transferring I
the cost of such losses to an insurance company for a competitive rate of premium, j
the firm is able to price its product appropriately.
1
Unit 2
itationof
trance or
decisions
rocess of
jpropriate
it work in
lastobea
(langeany
ness.
s you have
)f business
aging such
i a loss.
rganization
ransferring
an risk and
pttomline
m insurance
id therefore
(transferring
If premium,
c. Risk Management can contribute to business profits at least in six indirect ways :
i. By insuring proper management of Pure risk the management of a firm ensures
for itself peace of mind and confidence, e.g. if an existing firm has to tap new
markets in an area of the country which is Earthquake prone, without a proper
Risk Management measure, the management may not venture into that area at
all for fear of Earthquakes. But if the Management has a proper Risk Management
for earthquake losses then they are free to venture into even such areas and they
will be able therefore to enhance their market share here.
ii. By handling pure risk aspects of speculative ventures the Management improves
the quality of decisions into such ventures. For e.g. if some hazardous material is
required for a manufacture of a product which is very much in demand, then by
a proper Risk Management procedure, the concern over storage and use of
such hazardous materials can be properly mitigated and the firm or enterprise is
in a position to improve its top line.
iii. Risk Management also ensures that there are no wild fluctuations in the cash
flows and the annual profits. This is done by proper Risk Management exercise
so that pure risk losses do not upset the balance sheet.
iv. Risk Management also helps ensure business continuity. Business continuity is
important particularly when you have valued customers in a highly competitive
market. If you are not in a position to continue supplies to these customers, then
they may migrate to other suppliers. Therefore by ensuring business continuity,
Risk Management helps you to retain your customers. Even customers, creditors
and suppliers strongly prefer a company with a proper Risk Management
philosophy, the reason being that they all know that this firm will continue to be
in business even in the case of major calamities.
v. By ensuring the peace of mind and well-being of the management, Risk
Management also transforms the Management into a valuable non economic
asset.
vi. Lastly, since Risk Management plans also take care of continuation of employment
as also work situation, losses to personnel, the business enterprise is able to
fulfill its responsibility to the society at large.
Risk Management, as we mentioned earlier is not necessarily confined only to business
and commercial enterprises. It also brings in benefits to individual and family units. Think
of a simple life insurance policy which is purchased by the head of a family. In the event of
the death of the earning member, the family is assured of financial protection. This Risk
Management tool of buying life insurance gives peace of mind to the family. Similarly,
proper storage of valuables helps the family to avoid the hassles of a burglary or a theft. An
insurance policy which can respond to this kind of grievance, further enhances the security
feeling of the family. Similar protection also ensures the well-being by the purchase of
health and medical insurances.
Âctivity G:
"Using the available resources to achieve maximum profit is the goal of Risk Manager."
Write down your views.
2.8 OBJECTIVES OF RISK MANAGEMENT

Any Management process begins with a statement of mission, a statement of objectives.
What could be the possible objectives of Risk Management? From the discussion of the
possible contributions of Risk Management, we can derive the possible objectives for the
Risk Management process. They are as follows:
1.
Continuity of the firm or individual.
2.
Peace of mind.
3.
Lower Risk Management costs and therefore higher profits.
4.
Stable earnings.
5.
Uninterrupted business operations.
6.
Continued growth.
7.
Fulfillment of responsibilities.
8.
Compliance of several obligations imposed by either society or legislation.
The above listing gives a fair range of the possible Risk Management objectives. However
the order in which any or many of this objectives are important to any organisation depends
upon the firm's general business objectives, e.g. some firms might be on the brink of a
disaster wherein, a mere survival will be their priority. Some firms which are ongoing will
Unit.
not only look at mere survival but also continuity and stable earnings. Ultimately, therefore
the Risk Management objectives for any organisations have to be integrated with the
business objective of the organisation.
Âctivity H:
Assume you are a Risk Manager of a firm. List down at least 5 points so that you can
increase the profit and minimize the severity of loss.
2.9 SUMMARY
In this unit we have introduce that Risk is everywhere and without risk nobody can progress.
Risk and uncertainty has economic value. As Risk cost may be of private and social cost;
that is why it must be managed to the benefit of the society. We have also discussed about
Risk Management Process. It consists of five steps and is the identification measurement
and treatment of Pure risk exposures in property, liability and personal areas.
Once the risks have been identified and measured various tools of Risk Management are
used to treat the exposures and ensure business continuity and profitability and stability of
business.
We have also discussed the treatment of Risk and how the risk management is beneficial
to the individual and society and play important role in success and survival of the
organization.
2.10 KEY WORDS
The Risk Management Process
Risk Management is the identification measurement

and treatment of pure risk exposures in property,
liability and personal areas
Treatment of Risks
Once the risks have been identified and measured

various tools of Risk Management are used to treat
the exposures.
Private Costs
Costs incurred by individual or firm engaged in a

particular activity.
Social Costs
30
Costs fall upon the society due to a particular

activity.
2.11 SELF- ASSESSMENT QUESTIONS

i. Limited Resources - Unlimited Risks. Give the challenges faced by and how,
the Head and only Earning member of a family is expected to handle them. You
s
gement Processes learnt in this unit.
h
ii. How does uncertainty affect an organization? Explain giving illustrations.
o
u iii. Does a Risk Management consciously practiced benefit a firm? Explain how?
l
d iv. You have been assigned to organize a one day Promotion Fair for publicising
your company's new Detergent powder. You have been given a reasonable
u
budget and five assistants.
s
e
You plan to conduct a Puppet show in a residential colony in your town.
t
Enumerate how would you go about the Risk Management Process in respect of
h
the
e
function?
v
v
a
v. Describe in brief the process of Risk
ri
o Management, vi. What are the obj ectives of Risk
u
s Management?
st
e 2.12 ANNEXURE___________________________________
p
s In the graphs included in the Annexure, we have:
i
Fig. 1 A sample Frequency Distribution of Fire Losses with the Rupee value in X
n
axis and No. of losses in the particular range, in Y axis - Figures for Indian
t
Insurance Industry.
h
e Fig. 2 Similar Rupee value of Fire claims and maj or losses on an annual total
value basis - Indian Insurance Industry.
R
is , Fig. 3 Claims Ratio: Claims Incurred by Indian Insurance Industry vs. Premium
k
Number of losses-year-wise Fig. 5 Average value of
M received. Fig. 4
a claims on a year-wise basis.
n
These graphs are intended to give you an idea of data organized in a manner to
a
make meaningful information available.
Unit 2
FIG. 1 - FREQUENCY DISTRIBUTION GRAPH OF TOTAL LOSS
ae ild
co
/our ;and
;tofthe
in X axis Insurance
total value in received.
ner to make
3
1
FIG. 2 - FREQUENCY DISTRIBUTION GRAPH OF TOTAL LOSS

500
400
300
200
100
CD
co
3.1 INTRODUCTION____________
The task of risk identification breaks down into two sub-parts:
1.
The perception of risk, that is the ability to perceive that there is an exposure, and
2.
the identification of the operative cause or perils, coupled to the likely result.
In this unit we will discuss about the various methods regarding perception of risk.
Risk identification is a process by which enterprises systematically and continuously identify
property, liability, Personnel exposures as soon as or before they emerge.
To identify all the potential losses, the Risk Managers need first the checklist of all the
losses that could occur to any business which includes information regarding -
1) Nature, size, scope of the business.

2) Method of activities for example production method, sub contractor's conditions,
etc.
V
3)
Place of activities that are at customers' premises or at shop floor etc.
4)
Physical, social, legal, or political background in which the enterprises have to work.
5)
Study of past records such as event analysis, check list etc.
6)
Prospective techno-marketing report, threat analysis. etc.
Taking into consideration all above methods, physical inspection of the premises is the
most realistic method.
Secondly, to evolve a systematic approach, the checklist can be used to discover which of
the potential losses are normally available with Risk Management Associations, Associations
of insurers, Loss Prevention Association of India, etc.
One must remember that no single method is likely to reveal all risks that an organization is
exposed, Secondly due to budget constraints the risk manager must choose the best possible
method which proves best and thirdly risk identification must be a continuous process.
In a generic checklist, the possible assets are divided into two major categories, of physical
assets and intangible assets.
Unit 3
Risk Identification -1
The possible exposures to loss are categorized as (1) Direct Exposures (2) Indirect or
Consequential Exposures and (3) Third Party Liabilities.
A detailed "Assets Exposure Analysis" Checklist is appended in the Annexure. This
checklist provides, perhaps, a good starting point. Other than using this, a Risk Manager can
also construct his own checklist, which needs a good amount of imagination. One should
study the losses already incurred by the Enterprise and losses reported in various Industry and
Business Press. Participating in International or National Risk Management meetings will also
help generation of ideas.
JÂctivity A:
A worker from a floor shop fell from a ladder and injured seriously. Identify the causes of the
accident.
Now we will see in detail the methods of identification used by risk manager.
3.2 APPLICATION OF CHECKLIST____________________________________
The second step in risk identification is to use the checklist so developed, to discover and
describe the types of losses faced by a particular business. Seven methods are suggested here
for this identification process.
1.
The Risk Analysis questionnaire
2.
The Financial Statement method
3.
The Flow Chart method
4.
On-site inspection
5.
Planned interactions with other departments
6.
Statistics of past cases
7.
Analysis of environment
No one method will comprehensively complete the identification process and similarly
identification is not an one-off process. Thirdly, while applying the checklist for Exposure
Analysis, some gaps may develop in the checklist itself, which should be rectified.
3.3 THE RISK ANALYSIS QUESTIONNAIRE
______________________________________________________________________
The risk analysis questionnaire does more than provide a checklist of potential losses. It
directs the risk manager to secure in a systematic fashion, specific information concerning
the firm's properties and operations like
a)
The nature of the organizations activities.
b)
Inter-relationships and inter-dependencies between various parts of the organization.
c)
Identification of profit and cost centre.
d)
Identification of people who provide technical support, make and implement risk
handling decisions.
e)
Organizational weaknesses which may exacerbate risk situations
To secure this information the Risk Manager will consider all the sources of information
used in the other six methods. The difference is that the questions in the questionnaire
direct the inquiry.
Âctivity B ;
As a Risk Manager list out exposure faced by a employees carrying cash from factory to
bank and to working site.
3.4 THE FINANCIAL STATEMENT METHOD

Second systematic procedures for determining which of the potential losses in the checklist
apply to a particular firm and in what way is the financial statement method.
By analyzing the balance sheet, operating statements, and supporting records, the Risk,
Manager can identify all the existing property, liability and personnel exposures of the firm. I
Units
By coupling these statements with financial forecasts and budgets the risk manager ca_n
discover future exposures. This fdlowg because every business transaction ultimately
involves either money or property.

Under this method, each account title is studied in depth to determine what potential
losses it creates. The results of the study are reported under the account titles. This approach
is reliable, objective, based upon readily available data, presentable in clear, concise terms
and applicable by either risk managers or professional consultants. Moreover it translates
risk identification into financial terminology that is more familiar, and consequently should
be more acceptable, to other managers in the firm and to outsiders such as accountants
and bankers. For example, from purchase and sales accounts it is possible to obtain
details of suppliers, customers, rent items reveals whether the vehicles, buildings are on
lease basis or own asset.
Finally, in addition to determining the best way to handle the exposure this tool must be
supplemented with the financial records with other sources of information such as an
inspection of the premises or legal documents. Analyzing the financial statements will suggest
these additional steps. For example, liabilities of construction contractor and sub-contractor
in case of injury or damage caused by contract work.
The following analysis illustrates in abbreviated fashion how one account title, coupled
with some appreciation of the various losses that could occur, can help to identify potential
losses:
Table 3.1
Account
Title
Personnel or
Activity
Specific Property
Loss
A. Potential Perils
Inventory
Raw materials:
In suppliers hands In
transit to warehouses, In suppliers
truck, Warehouse, In
transit to
manufacturing plant,
In firm's own trucks,
Manufacturing Plant
Property
losses: Direct
-Indirect -Net
Income
Fire windstorm,
explosion, other
physical perils,
Vandalism, Risk
burglary, other
human perils
Finished Goods:
Manufacturing
Plant, In transit to
Warehouse, Firm's
own truck, Common
Carrier, Warehouse,
In transit to
retailers,
Firm's own truck,
Common Carriers,
liability
losses
arising out
of truck,
premises,
Products,
injuries to
employees
In
inde
pen
dent
Per
son
nel
reta
ilers
'
han
ds
losses to
firm/family
Negligence, breach
of warranty, injuries
to employees
(workmen's
compensation)
Automobile
accidents (no fault)
Death, poor health,
unemployment,
retirement.
The study of these record helps not only to provide evidence of potential losses but also
loss probabilities and severities which helps risk manager to measure the risk.
This method does not reveal the work processes and the physical layout of plants, to
obtain this information, we will study flow charts.
Âctivity C:
As a Financer Officer of a bank, you want to finance a sick unit. Identify the risk factors
revealed from books of accounts, profit and loss account and balance sheet of a firm.
3.5 FLOW CHART METHOD

To know the work processes and physical layout of the plant we have to study the Flow
Chart. Hence a third systematic procedure for identifying the potential losses facing a
| particular firm is the Flow-Chart approach.
Unit 3
Flow Chart Method

Supplies
Receiving
Room
Storage
Manufacturing
Paintshop
Pac ring
i ___
,
Fig 3.1
First, a Flow Chart or series of flow charts is constructed, which shows all the operations
of the firm, starting with raw materials, electricity, and other inputs at suppliers locations
and ending with finished products in the hands of customers. For example, Figure above
shows the major operations of a hypothetical firm. More detailed pictures can and should
be prepared. Second, the checklist of potential property, liability and personnel losses is
applied to each property and operation shown in the flow chart above, suggests, among
others, the following potential losses:
Property Losses :
Replacement or repair of trucks, manufacturing plant, machinery, raw materials goods in
process, or finished goods, subject to physical and human perils on the manufacturing
premises or in transit.
Shutdown or slowdown of manufacturing operations because of direct property osses. 1
Liability Losses :
Liability for bodily injury or property damage to customers because of defective products,
to visitors because of defects in the premises, and to others because of negligence of the
firm's trucks.
Legal responsibility under (1) the workmen's compensation law for bodily injuries to
employees and (2) Automobile no-fault laws.
Personnel Losses :
Losses to firm because of death or disability of key employees.
Thus flow chart can help to reveal the exposure of an organization to risks of disruption of
its business.
^ Activity D ;
List out major points for a Flow Chart of a chemical factory.
3.6 ON-SITE INSPECTION____________________________________________

On-site inspections are a must for the Risk Manager. By observing firsthand the firm's
facilities and the operations conducted thereon the Risk Manager can learn much about
the exposures faced by the firm as it reveals,
v
1.
Standard of house keeping
2.
Raw material used, whether it is non-hazardous, hazardous or extra hazardous
3.
Nature of process carried on
4.
After completion of each stage of process, the nature of production
5.
Storage arrangement of final product
6.
Past claim records.
It also helps to reveal organizational weaknesses, inter-relationships and inter-dependencies

between various departments.
3.7 INTERACTIONS WITH OTHER DEPARTMENTS

A fifth way to identify the losses facing a business is through systematic and continuous
interactions with other departments in the business.
Included among these interactions are

(1) extended visits with Managers and employees of other departments during which the
Risk Manager attempts to obtain a complete understanding of their activities and the
potential losses created by these activities and
Unit 3
(2) Oral or written reports from other departments on their own initiative or in response
to a regular reporting system that keeps the Risk Manager informed of all relevant
developments. These departments are constantly creating or becoming aware of
exposures that might otherwise escape the risk manager's attention. Indeed the Risk
Manager's success in risk identification is heavily dependent upon the cooperation
he or she secures from other departments.
Unfortunately, Risk Managers often hear about new exposures long after they are created.
For example, one Risk Manager was surprised to learn from his morning newspaper that
his employer had purchased an expensive River Barge two weeks earlier. As a result, for
two weeks the firm was exposed to some serious property, liability and personnel losses
that were ignored in its risk management planning. Moreover, if these losses had been
explicitly considered, the firm might have even decided not to buy the barge, instead
would have chartered one.
/Âctivity E:
You have done a site inspection of factory manufacturing soft drink. Write down inspection
report taking into consideration the facts you have revealed during the inspection and
laboratory reports of the sample.
3.8 STATISTICAL RECORDS & LOSSES

A sixth approach that will probably fewer exposures than the others will but which may
identify some exposures not otherwise discovered is to consult statistical records of losses
or near losses that may be repeated in the future.
From statistical record frequency of losses as well severity of accident reveals. It also
provides records of past losses including details of insurance claims which is a valuable
information for the Risk Manager.
3.9 ANALYSIS OF THE ENVIRONMENT

A careful analysis of the external environment as well as internal exposures is a very useful
approach to identifying the exposures of a particular firm.
Following structure suggested identifies four components of the 'relevant' environment (1)
customers (2) suppliers (3) competitors and (4) regulators.
In analyzing each of these components, important considerations are the nature of the
relationships, their heterogeneity, and their stability.
For example, is the product distributed directly to one group of buyers or indirectly, through
wholesalers and retailers. To many persons? Are the customers families, businesses, or
government agencies? Are there single or multiple suppliers of important services? What
contractual arrangements have been made with suppliers? Does competition with others
require speedy advertising campaigns and possibly encourage improper product claims ?
What special obligations are imposed by outsiders such as government regulators,
consumers and unions? How rapidly are these relationships changing?
Study of environment or market survey is very important when a new product is going to
be lunched in the market. A firm may fail to sell its product at proper price due to better
quality product may available in the market may be in lesser price, change in the customers'
tastes or fashions or change in government policies.
To manage this risk proper use of market survey and market research on regular basis is
necessary.
xgT Activity F-.
State in few words the effect on production of cold drink due to ban on it by government.
46
UnitS
3.10 SUMMARY
Ifi this we have introduced the concepts of Risk Identification and various methods applied
for this process. With the help of this we can find out the various risks and probable losses
which the firms have to face in future. We have also discussed that Risk identification is a
never ending task and no one method gives full information about the exposure to which
an organization is exposed hence as we have discussed various benefits of each method
and how these methods help the risk manager in his j ob combination of all techniques must
be used.
To carry out risk identification process effectively a risk manager needs a good imagination
with periodic review of decisions.
3.11 KEY WORDS

Risk Identification
Is a process by which enterprises systematically and

continuously identify property, liability, personnel
exposures as soon as or before they emerge.
Asset Exposure Analysis
Is a check list which list out all the assets and the
corresponding exposures as well as various liability
exposures. Serves as a starting point for use of other
identification tools.
Flow Chart Method
Uses the operations of the firm in a process sequence

to help identification of risks and exposures at
various stages in the sequence.
Financial Statement Method
Uses the various financial information like Balance

Sheets to identify all types of exposures.
3.12 SELF-ASSESSMENT QUESTIONS

1.
List out factors to be considered to identify a loss.
2.
Explain how the questionnaire give systematic information about organization?
3.
How the scrutiny of financial statements reveals the true picture of each department
which creats potential losses?
4.
Comment on "on site inspection is necessary where hazardous and extra hazardous
process involve."
ASSETS - EXPOSURES ANALYSIS
Assets
Physical Assets :
Real Property (a)
Buildings
(1) Under Construction
(2) Owned or Leased
(3) Manufacturing
(6) Garages & Hangers

(7) Dwellings and farms
(8) Tanks, Towers and Stacks
(9) Wharves & Docks
(4) Offices
(10) Pipes & Wires
(5) Warehouses
(Above ground)
(b) Underground Property

(1) Cables and wires
(2) Tanks
(3) Shelters, caves &
Tunnels
(4) Mines and Shafts

(5) Wells, groundwater
(6) Piping and pipelines
(c) Land:
(1) Improved
(2) Unimproved
Personal Property (on and off premises and in transit) (a)
Equipment and Machinery
(1) Machines and tools
(2) Dies, jigs, moulds, castings
(3) Boilers and pressure vessels
(a) Fired vessels - steam and hot water boilers
Unit3
(b) Unftedvessds
transformers, generators, motors, fans,

pumps, compressors Engines-diesel,
gasoline, steam Meters and gauges
(5) Turbines-steam, gas, water
(6) (a) Conveyors and lifts, trams, elevators
(b) Furniture and fixtures
(c) Electronic data processing equipment
(d) Improvements and betterments
(e) Stock-supplies, raw materials, goods in process finished goods
(f) Fine arts-antiques, paintings, jewellery, libraries
(g) Safety equipment - instruments, apparel, alarms, installations
(h) Valuable Papers
(1) Blueprints
(2) Formulas
(3) A/Cs. Receivable
(4) Patents & Copyrights
(5) Titles and deeds
(6) Tapes, cards, disks, programme
(7) Own securities-negotiable & Non-negotiable
(8) Other corporate securities
(9) Cash (indicate currency)
Miscellaneous Property -
(1) Commercial
(2) Private passenger
(3) Contractor's equipment (licensed)
(4) Warehouse equipment
(b) Aircraft (1) Missiles and satellites
(2) Lighter than air
(3) Aircraft-jet, piston, fixed wing, rotary wing
(c) Animals
(d) Antennas
(e) Crops, gardens, lawns
(f) Fences
s
(g) Firearms
(h) Nuclear and radioactive property isotopes, tracers, Reactors, cyclotrons,
accelerators, betatrons
(i) Promotional displays-signs, models, plates, handbills, exhibits
(j) Recreational facilities-parks, gyms, lakes, cafeterias
(k) Watercraft (including contents) boats, yachts, barges, ships, Submersibles, buoys
drilling rigs.
Intangible Assets
(Assets not necessarily shown on balance sheet or earnings statement) 1.
External assets
(a) Markets
(b) Resource availability
1.
2.
3.
4.
5.
Unit 3
Supplies
Transportation
Employees (fulltime and temporary)
Public utilities
Public Protection
îdentification'
(c) Communications
Telephone, teletype, television, radio, newspaper
(d) Locational climate, political, economic and social stability, currency convertibility.
(e) Council and specialists - legal, architecture, accounting, insurance, real estate,
general management, marketing, advertising PR, Banking.
2. Internal Assets :
(a) Research and development
(b) Goodwill and reputation
(c) Financial
(1) Credit cards
(6)
(2) Credit lines (reed.)
(7)
(3) Insurance
(8)
(4) Customer credit
(9)
(5) Employee Benefits
(10)
Royalties & Rents

Leasehold interest
Ownership of stock Cofoundations (Non-profit)
Tax loss carry-forward
Programme
(d) Personnel (employees and executives)
(1) Education and training
(2) Experience
(3) Key employees
(e) Rights
(1) Mineral and oil right-above ground, underground and offshore
(2) Air rights
(3) Patents and copyrights
Exposures to Loss
A. DIRECT EXPOSURES
1. Generally uncontrollable and unpredictable
(a) Electrical disturbances lightning, burn-out, sunspots,
power surges,
demagnetisation of tapes
(b)
Fall
ing
obje
ctsairc
raft,
met
eors, missiles, trees
pressu
(c) Land movement-earthquake, volcano, landslide, avalanche
re (i)
(d) Sound and shock waves-sonic boom, vibration, water hammer
Fauna
(e) Subsidence-collapse, settlement, erosion
(f) War insurrection, rebellion, armed revolt, sabotage
anima
(g) Water damage-flood, rising, waters, flash flood, mudslide,

tidal waves
(tsunami), geyser, groundwater, sprinkler, leakage, sewer
backup
(h) Weight of ice, snow
(i) Windstorm - typhoon, hurricane, cyclone, tornado, hailstorm,
rain dust, sandstorm.
2. Generally controllable or predictable
(a), Breakage of glass or other fragile items
(b)
Breakdown - malfunction of part, lubricant etc.
(c)
Collision, on and off premises-watercraft, aircraft, vehicles
(d)
Contamination - liquid, solid, gaseous, radioactive, pollution
(e)
Corrosion - wear, tear, abuse, poor maintenance
(f)
Employee negligence
(g)
Explosion and implosion
(h) Failure of environmental control - temperature, humidity,
ls,
roden
ts,
insect
s,
pests
(j) Fire
(k) Installation and construction hazards - dropping etc.
(I) International destruction-jettison, backfiring etc.
(m) Perils of sea - pirates, rovers, barratry etc.
(n) Physical change - shrinkage, evaporation, colour, mildew, expansion,
contractions.
(o) Rupture or puncture of tank or vessel
(p) Smoke damage, smudge
(q) Spillage, leakage, paint spray
(r) Structural defects, crane or ele vator fall

(s) Transportation - overturn, collision
(
't) Unintentional error - employee, computer, counsel
in) Vegetation
(v) Vandalism, malicious, mischief, defacing of property
(w) Riots, civil disorders, strikes, boycotts,.curfews
Primarily financial in nature (a) Employee dishonesty - forgery, embezzlement, larceny
(b) Expropriation - nationalization, seizure, exercise of eminent domain,
confiscation
i c) Fraud, forgery, theft, burglary, robbery
i d) Invalidity of deed, title, patent, copyright
*e) Inventory shortage-mysterious disappearance, lost of mislaid property
')) Obsolescence
1 . All direct Exposures as they affect :

(a)
Suppliers
(b)
Customers
Unit 3
(j)
Fire
(k) Installation and Construction Wards-dropping etc.

(1)
International destruction-jettison, backfiring etc. (m)
Perils of sea-pirates, rovers, bonaliy BIC.

(n) Physical change-shrinkage, evaporation, colour, mildew, expansion,
contractions.
(o) Rupture or puncture of tank or vessel
(p) Smoke damage, smudge
(q) Spillage, leakage, paint spray
(r)
Structural defects, crane or elevator fall
(s)
Transportation - overturn, collision
(t)
Unintentional error - employee, computer, counsel
(u) Vegetation
(v) Vandalism, malicious, mischief, defacing of property
(w) Riots, civil disorders, strikes, boycotts,.curfews
3. Primarily financial in nature (a)
Employee dishonesty - forgery, embezzlement, larceny
(b)
Expropriation - nationalization, seizure, exercise of eminent domain,

confiscation
(cf fraud, forgery, theft, burglary, robbery

(d) Invalidity of deed, title, patent, copyright
Inventory shortage-mysterious disaprjearanc
(f)
Obsolescence
INDIRECT OR CONSEQUENTIAL EXPOSURES 1.

All direct Exposures as they affect:
(a)
Suppliers
(b)
Customers
(c)
Utilities
(d)
Transportation - personnel and property
(e)
Employees
2.
Extra expenses, rentals, communication, product etc.
3.
Concentration of assets
4.
Change in style, taste, desire
5.
Bankruptcy - employee, executive, supplier, customer, counsellor
6.
Disruption of education system - racial, political economic
7.
Economic fluctuation inflation, recession, depression
8.
Epidemic, disease, plague
9.
Increased replacement cost, depreciation

V
10. Invasion of copyright, patent

11. Loss of integral part of set, pair, group
12. Loss of rights resulting from records destruction
13. (a) Pricing,marketing
(b). Distribution
(c)
Production
(d)
Expansion
(e)
Economic Predictions
(f)
Political Predictions
(g)
Investments
(h) Dividend declaration (i)

Tax filing
14. Recall of product
15. Spoilage
Unit3
C. THIRD PARTY LIABILITIES (COMPENSATORY AND

PUNITIVE DAMAGES)
1.
Aviation Liability
(a)
Owned and leased aircraft
(b)
Non-owned - Officers and employees licensed
(c)
Grounding and sister - ship liability
2.
Athletic - Sponsorship of teams, recreational facilities etc.
3.
Advertiser's and Publisher's Liability
4.
5.
(a)
As agents
(b)
Libel, slander, defamation of character
(c)
Media use - radio, TV, Newspaper, samples, exhibits
Automobile Liability
(a)
Operation of vehicles - owned or non-owned
(b)
Loading and unloading
(c)
Dangerous contents - flammables, explosives
Contractual Liability
(a)
Purchase agreements
(b)
Sales agreements
(c)
Lease agreement - real or personal property
(d)
Performance or service
(e)
Loans, mortgages, notes
(f)
Hold-harmless clauses
(g)
Surety agreements
6.
Directors and Officers Liability
7.
Easements
(a)
In gross
(b)
Appurtenant
(c)
Positive or negative under common law
(d) Rights or access of light, water, drainage, support 8.

Employer's Liability
(a)
Pensions, trusts, profit sharing plans, investments
(b)
Insured - life, accident, health etc.
(c)
Discrimination in employment
9. Fiduciary and Fringe Benefits plans liability
(a)
Pensions, trusts, profit sharing plans, investments
(b)
Insured - life, accident, health etc.
(c)
Credit society
10. Malpractice Liability
(a)
Medical doctors, nurses, specialists
(b)
Lawyers
(c)
Engineers
(d)
Trustees of pension plans
(e)
Patent infringement
11. Ordinary negligence
(a)
Of employees
(b)
Of agents
(c)
Of invited or uninvited guests
(d)
Of contractors or subcontractor
(e)
Failure to provide safety equipment, warnings etc.
(f)
Inadequate enforcement of regulations
(g)
Improper Preparation of food
12. Non-ownership Liability
(a)
Leased real or personal property
(b)
Bailee's Liability
(c)
Employees use of vehicle, aircraft, watercraft
13. Owner's Liability
:. (denlification -1
Attractive nuisance
> Invited guests

1
Trespassers (false arrest)
; I Rights of others - riparian, mineral, light, air, view, lateral support, easement
walls, licenses, drainage, eminent domain.
oduct Liability (each product sold, distributed, made)
.) Implied Warranty
) Express Warranty
(1)
By agents - sales, advertising, or general
(2)
By employees
(3)
Ofmerchantability
(4)
Of suitability or fitness for use
(5)
Oftitle
(6)
By sample
! elective Liability
i) Industrial Contractors hired i
Construction or demolition -.u.oad
Liability i) Sidetrack agreements :')
Right of way ) Grade Crossings
Jirectors and Officers Liability (Stockholder derivative suits)
Watercraft Liability
Ownership, leased, operation
Types-boats, yachts, ships, submersibles, rigs, platforms.
Reference from Risk Management by HI.
4.1 INTRODUCTION
In the previous unit we have discussed various methods regarding perception of risks. In
this unit we will see in detail about various methods of the identification of the operative
cause or perils coupled to the likely result.
There are several techniques for carrying out the analysis of risk identification process and
there are other sophisticated methods which aim to identify the operative cause or perils in
conjunction with the likely result. Some of them are detailed below:
4.2 THREAT ANALYSIS
An alternative approach to the check list is to compile a list of the threats to the business.
Take, for example, the threat of denying access to the place of business for which the
completed form may appear as in Table below. Denial of access to premises can arise
from many causes, for example quarantine regulations following epidemic, collapse of
nearby buildings, blocking the road, burst water/gas mains preventing access, strike,
picketing, government order and so on. The threats to the business in terms of both the
severity and duration of the interruption probably would vary as shown.
Table 4.1
Threat
Cause
Denial of (i) Strike

Access
Result
Mitigating
Factors
Loss Assessment
Damage
Business
Interruption
Partial
closure or
total closure
Good
industrial
relations
Nil
2-5 weeks
(ii) Pickets
Total
closure
Suppliers
not
vulnerable
Nil
1-2 months
(iii) Road
subsidence
Total
closure
Second
access to rear
through
adjoining
factory yard
Nil
1-2 days
Unit 4
Risk Identification - II
Loss of
(i) Burst
services
Main
Total loss
Second
of process
Supply
(1) Water (ii) Frost

(iii) Drought
and usable
water
Partial loss
likely to
cause
cessation
of operations
available
In
catchment
area with
high
reserve
capacity
Nil
Prolonged
seasonal
period
Like this any threat to the business can find out with its causes, results loss assessment etc.
Âctivity A:
There is a shortage of water supply to a Hospital. Draw a threat analysis table for this
taking into consideration its causes, effect on hospital working, assessment of loss due to
loss of service.
4.3 EVENT ANALYSIS

Event analysis is a technique for considering likely events which could cause problems and
then investigating cause and effects. It is illustrated in figure below. The varying impact
between cause and effect is a function of the 'event' ; for example, consider the event as
'failure of boiler services' . There are many potential causes, ranging from that of explosion,
to burst water tube, to failure of the priming pump.
The effect of these three causes giving rise to the same event would be quite different. An
explosion could lead to major interruption of processes, the destruction of property, and
loss of life, including potential third party liability. On the other hand a burst tube may result
in only minor interruption, with no property damage or personal injuries. At the other end
of the spectrum, the failure of the water priming pump may have no effect at all if a stand
by pump can be brought into service immediately.
CAUSE
EFFECT
LIABILITY
DAMAGES
LOSS
PRODUCING
EVENT
PROPERTY
DAMAGES
BODILY INJURY
LOSS OF
EARNINGS
NATURAL
PHENOMENON
BREACH OF
NATURAL LAWS
HUMAN
ACTIVITIES
Fig 4.1
.gTActivity B :
Consider the event "Fire in a cotton factory". Find out its causes and effects with event
analysis technique.
4.4 HAZARD LOGIC TREES (HLT)
Such analysis can be aided by the use of Hazard Logic Trees (HLT) whereby the various
hazards which may precipitate the operation of the peril which is the cause of the loss
producing event can be identified. As the name implies, it is simply another technique for
forcing one to carry through the exposure analysis process in a methodical, logical manner.
In order to illustrate the technique, Figure below takes the example of another type of loss
producing event, the loss of warehousing facilities. The lists of hazards shown are not
exhaustive, and those applying in any particular case will be dependent upon local
circumstances. Imagination plays an important role in the construction of HLTs, and the
Unit 4
Prima facie remoteness of either perils of hazards does not justify their omission from the
lists; for too frequently it is the unexpected event which does occur.
Table 4.2
LOSS PRODUCING EVENT
-LOSS OF STORAGE
FACILITIES
FIRE OR
EXPLOSION
WATER DAMAGE
ARSON
SMOKING
FOOD
STORM
BURST PIPE
CLOSURE
ELECTRICAL
HEATING
BURST MAINS
SPONTANEOUS
COMBUSTION
OTHER FORMS
OF DAMAGE
DENIAL OF
ACCESS
AIRCRAFT
VEHICLE
FLOOD
SUBSIDENCE
MALICIOUS ACTS
SUBSIDENCE
ROAD
EPIDEMIC
HURRICANE
CHEMICAL
INTERACTION
BOILER EXPLOSION
SPREAD OF FIRE
FROM OTHER
LOCATION
One advantage of constructing HLTs is that it forces one to breakdown the potential
causes of loss producing events into their smallest components. Thereby providing at least
a subjective pointer to the probability and severity of those events. It is also of value at the
risk handling state, in that the identification of hazards is a prerequisite to the implementation
of measures to control them.
Âctivity C :
a) With the incidence given below prepare Hazard logic tree:
b) Loss producing event - Shortage of supply of Raw Material to a manufacturing

factory.
4.5 HAZARD AND OPERABILITY STUDIES

Such a study is designed to be used at the planning stage of a new plant. The objective is
to examine the process as a whole in order to identify potential deviations from normal
operating conditions, their causes and possible consequences.
The technique, which was developed by imperial Chemicals Industries Limited, is for a
small team to examine every stage of a process by applying a number of guide words as
shown in Table below.
List of Guide words

Guide Words
Meaning
For continuous
Process
NONE
For batch
Process
NO or NOT
Complete negation of the design Intention.
MORE OF
MORE
Increase in flow, pressure etc.
LESS OF
LESS
Decrease in flow, pressure, etc.
PART OF
PART OF
Some of the intent in is achieved e.g., the

composition of the system is different from
what it should be.
Unit 4
MORETHAN
AS WELL AS
REVERSE
OTHER
THAN
Additional
component or
phase present
or
another
activity occurs
concurrently.
What else can
happen apart from Normal operation e.g.,

startup, shutdown, maintenance etc.
Opposite of the design intention e.g., reverse
flow or chemical reaction.
Something quite different from the design
intention.
For some example, in looking at the thermal reactors in a chemical factory the use of the
guide word NO would lead to an examination of the ways in which there could be no
transfer from the raw material storage or no supply of gas to the reactors, such as the raw
material stores being empty or a pipeline being fractured. Likewise, the words MORE OF
or LESS OF would direct attention to ways in which there could be increases or decreases
in the flows or pressures of materials or gas. The next step would be to consider the
possible causes and consequences of such events occurring.
4.6 THE DOW INDEX
In the 1960s the Dow Chemical Company in the U.S.A., developed a system for the
identification and evaluation of fire and explosion hazard potential based on a study of
many plant accidents and near misses. It has subsequently been developed to cover storage
units, and loading and unloading operations, and it can be applied to either the planning
stage of new plants, to existing plants, or to a consideration of alternative processes in an
existing plant.
The technique is to:
list all raw materials, work in progress, products, by-products and catalysts present
in a plant;
identify the dominant material on the basis of (a) quality present and (b) fire potential,
decomposition potential, or reactivity with other materials present;
quantify the hazards according to heats of combustion, decomposition or reaction;
apply additional factors to allow for such special features as the quantity of material
involved and the type of process.
The rating factors in the Dow Fire and Explosion Guide are based on operating and loss
experience. No credit is given for safety features, since it was the intention to employ the
Guide to identify needs for safety features.
Âctivity D ;
List out the hazards using Dow Index method in a factory manuf acturingliydrocloric acid.
4.7 FAULT TREE ANALYSIS

EXPLOSION IN OPEN PAINT
SPRAYING BOOTH
Sources of ignition
Flammable paint
spray in explosive
concentration
Fig 4.2
Essentially, the tree is constructed by asking what must occur before the loss producing
event, shown at the top of above figure, can occur. As shown, two conditions are required
to cause an exolosion. a concentration of flammable paint vapour within the explosive
Unit 4
limits and (denoted by the symbol) a source of ignition. The next step down the tree
is to investigate possible sources of ignition which are an electrical spark or nearby
flames or lighted cigarettes. The latter may be introduced by the operative or
someone else, whereas an electrical spark may be caused by a failure of the earthing
system. And so on until all possible events that may lead to the loss producing event
have been identified.
ousek
eepin
g
stand
The analysis can be refined further to assist in calculating the probability of the loss
producing event occurring by estimating the probability of each of the events on
the basis of past experience, and using that date to produce final conditional
probabilities.
xgTActivity E:
Write few lines on use of fault tree analysis in the risk identification.
4.8 SAFETY AUDITS

A. system that brings together the various techniques relating to both the perception of
risk and the identification of operative causes and perils is the safety audit.
\n audit may be undertaken either internally or outside consultants or by
combination of >oth. The management must define exact reference about audit.
The audit team must have knowledge about:
a) The organization, its activities

b) All regulations relating to the safety of its operations and products.
\fter verifying all these details, auditors proceeds towards analysis of the hazards
and lerils to which the organization's activities are exposed. Discussion with
management and ;raployees, also spot inspection is carried out if necessary. For
example, when assessing he fire and explosion following checklist must be take
into account:
Fire resistance of the
building
Flammability of materials
ards
Sources of ignition
Fire alarm and extinguishing systems
Security and security patrols
Fire training to employees
Proximity of the local fire brigade
Water sources
Means of escape
Further investigation is also carried if necessary.

Finally report is prepared stating:
1)
An analysis of the risk to which the organization is exposed.
2)
Recommendations for improving safety, contingency planning.
Thus a safety audit not only includes identification of risk but also evaluate and handling it.
Âctivity F:
Comment on' 'Safety audit is a critical examination of industrial operations to identify risks
and hazards."
4.9 SUMMARY
We have discussed the usefulness of the various techniques described above, the following
points are of relevance. The check list system suffers from the fact that it pre-identifies
perils/hazards, leaving the possibility that unidentified perils and hazards may not be
addressed.
Threat analysis is a crude means of ascertaining potential exposure by a broad examination
of the business and its environment. Event analysis is a much more specific technique,
which can be varied to suit circumstances from the 'broad brush' event analysis down to
the consideration of specific hazards.
Unit 4
Similarly hazard and operability studies help to pinpoint at the planning stage of a
project possible design defects which may lead to the occurrence of loss producing
events. Finally, the Dow Index and Fault Tree analysis can be used to assist in the
identification of hazards and in the quantification of risk.

At the end we have discussed regarding safety audit which brings various
techniques together to find out risk, causes and perils
4.10 KEYWORDS
Threat Analysis
It is a method for identification of various threats to the

enterprise, identifying their cause and result of such threat
as well as exploring the factors, which can mitigate the
threat as also, estimate the losses if threat materializes.
Event Analysis
It is a technique for considering likely events which could

cause problems and then investigating causes and effects.
Hazard Studies
It enables to examine the process as a whole in order to identify

potential deviations from normal operating conditions, their
causes and possible consequences.
The Dew Index
This method is developed for identification and evaluation of

fire and explosion hazard.
Fault Tree Analysis
This can be quantity the risk and identification of hazard.
Safety Audit
In addition to risk identification it helps in risk evaluation and

risk handling decisions.

i.
Why do you have to identify Risks ?
ii.
How do you start off in the identification process?
iii You are a senior person in the Finance Department of an Automotive Sales
outlet. Try to use any two of the identification methods you have studied in the
unit to efficiently map the risks your firm faces. You should state the business
profile, manpower, etc. of your firm before attempting this.
iv. List the advanced identification tools enumerated in this unit and briefly explain the
purpose and method used in each.
M/s. Narde & Banda are in the business of publishing books for Universities. They
have their own printing press located in a congested area of the city. The firm employs
forty workmen and five senior employees. They have a godown for the storage of
raw materials like paper, binding materials, as well as finished goods like bound
books. The godown is part of the printing press building. A major fire takes place in
the early hours of a Sunday. Fire Brigade is summoned and they are unable to pinpoint
the exact cause of the fire. However, the Risk Consultant of the firm is expected to
advise them on the cause aspect. Suppose you were the Consultant, how would you
use one of the methods studied in this chapter, to do the identification? List out the
assumptions you make before you attempt this.
v.
Write short notes on:
a)
Event analysis.
b)
Fault tree analysis.
vi. How do checklist helps in risk identification?
vii. What is the role of safety audit in the identification of hazards in the industrial
operations?
70
Unit 4
NOTES
5.2 DIMEN
5.1 INTRODUCTION
After the Risk Manager has identified the various types of potential losses faced by his or
her firm, these exposures must be measured in order
1 ) to determine their relative importance and
2) to obtain information that will help the risk manager to decide upon the most desirable
combination of risk management tools . Risk Manager should use probability concepts
in identifying and analyzing loss exposures
and in choosing alternative ways of handling exposures.
In particular, probability concepts are used to estimate :
1 ) The average number of losses or average aggregate amounts of losses from a specified
peril in a given period.
2) The variability around these averages of the number of losses or aggregate amount of
losses per period.
Risk handling decisions can be taken only after monitoring the risk reduction measure-and
other information like frequency and severity of loss producing events and other costs.
Therefore relevant data must be collected , collated , analysed and the results interpreted.
Information is needed concerning two dimensions of each exposure
1 ) The loss frequently or the number of losses that will occur.
2) The severity of those losses.
For each of these two dimensions it would be desirable to know at least the value of an
average budget period and the variation in the values from one budget period to the next.
The total impact of these losses if they should be retained, not only their monetary value,
should be included in the analysis.
The collection and the interpretation of information forms an important part of risk
management function. Interpretation of data involves the use of statistical data and probability
concept.
Unit 5
Risk Measurement
Âctivity A:
Which steps you will take if you want to find out number of exposures of your unit?
5.3 NEED FOR EACH DIMENSION

Both loss frequently and loss severity data are needed to evaluate the relative importance
of an exposure to potential loss. Contrary to the view of most persons, however, the
importance of an exposure to loss depends mostly upon the potential loss severity, not the
potential frequency.
\ potential loss with catastrophic possibilities, although infrequent, is far more serious than
me expected to produce frequent small losses and no large losses. On the other hand,
loss frequency cannot be ignored. If two exposures are characterized by the same loss
severity, the exposure with a certain potential loss severity may be ranked above a loss
with a slightly higher severity because the frequency of the first loss is much greater than
that of the second. There is no formula for ranking the losses in order of importance, and
different persons may develop different rankings. The rational approach, however, is to
place more emphasis on loss severity.
\n example may clarify the point. The chance of a automobile collision loss may be greater
than the chance of being sued as a result of the collision, but the potential severity of the
liability loss is so much greater than the damage to the owned automobile that there should
>e no hesitation in ranking the liability loss over the property loss.
i flood damage also amount of property damage is less than the liability arises due to
loss
i lives.
T Activity B :
rite down any incidence in which liability loss is greater than property loss.
5.4 RISK EVALUATION

A particular type of loss may also be subdivided into two or more kinds of losses depending
upon whether the loss exceeds a specified amount.
For example, consider the collision loss cited in the preceding paragraph. This loss may be
subdivided into two kinds of losses:
1)
collision losses upto Rs. 10000 and
2)
losses over Rs. 10000.
In the second category are the more important although they are less frequent. Another
illustration would be the losses associated with relatively small medical expenses as
contrasted with extremely large bills. Such a breakdown by size of loss shows clearly the
desirability of assigning more weight to loss severity than to loss frequency.
In determining loss severity the risk manager must be careful to include all the types of
losses that might occur as a result of a given event as well as their ultimate financial impact
upon the firm. Often, while the less important types of losses are obvious to the., risk
manager, the more important types are much more difficult to identify. The potential direct
property losses are rather generally appreciated in advance of any loss, but the potential
indirect and net income losses (such as the interruption of business while the property is
being repaired) that may result from the same event are commonly ignored until the loss
occurs. This same event may also cause liability and personnel losses.
The ultimate financial impact of the loss is even more likely to be ignored in evaluating the
monetary value of any loss. Relatively small losses, if retained, cause only minor problems
because the firm can meet these losses easily out of liquid assets. Somewhat, larger losses
may cause liquidity problems, which in turn may make it more difficult or more costly for
the firm to borrow funds required for various purposes. Finally, very large losses may have
serious adverse effects upon the firm's financial planning, and their impact may be much
greater than it would be for a firm that could more easily absorb these.
Âctivity C :
Write your views on "To determine a loss severity of a firm is an important task of Risk
Manager".
UnitS
Risk Measurement
5.5 LOSS-FREQUENCY MEASURES

One measure of loss frequency is the probability that a single unit will suffer one type of
loss from a single peril. For example, there is the probability that one building will be
damaged because of the fire or the negligent manufacture.
Richard Prouty, the risk manager of a large U.S. business group, suggested about 25
years ago that instead of using numerical estimates, the risk manager might express this
type of probability as
1.
Almost nil (meaning in the opinion of the risk manager the event will not happen)
Example: Possibility of accident to motor car due to part of plane drop down from
space is almost nil.
2.
Slight (meaning that, though unlikely to occur in the future)

Example: Possibility of theft of truck is slight.
3.
'Moderate' (meaning that it has happened once in a while and can be expected to
occur sometime in the future)
Example: Possibility of arising third party property claims is moderate.
"Definite" (meaning that it has happened regularly and can be expected to occur
regularly in the future).
Example: Occurrences of own damage claims to motor vehicles are definite.
hough not as precise as the probability measurements, these measures have the advantage
sat, given time to think about the exposures and study past experience, most risk managers
an provide the necessary estimates. Making these estimates also encourages a more
areful systematic approach to risk management.
istead of estimating the probability that a single unit will suffer one type of loss from a
ngle peril during the coming year, the risk manager, can, in the same way, estimate the
robability that the unit will suffer that type of loss from many perils, say windstorm and
\plosion as well as fire. This probability will be higher because of the additional possible
auses of loss. The probability category may or may not be higher, depending upon the
sagnitude of the increase.
Another example is the probability that a single unit will suffer simultaneously more
than | one type of loss (for example, physical damage to a building, loss of the use of that
building, I and liability for bodily injuries or property damage to others) from the single
peril. This
probability will be lower because more than one type of loss would have to result from a
single occurrence the probability category may or may not be lower.
Another example is the probability that at least one of several units, say five buildings, will
suffer the same type of loss from the same single perils. This probability will be higher than
the probability that any specific unit would suffer such a loss because there are several
units that may have a fire. The losses ultimately the loss could be the ruin of the business as
going concern.
Âctivity D :
Give two examples for the following:
1)
Single unit suffers from one type of loss.
2)
Single unit suffers from many types of losses.
3)
Several units suffer from one type of loss.
5.6 PREDICTION FROM SAMPLES
'f;
To illustrate, a fire could destroy a building and its contents valued at Rs. 3,00,000; the
ensuing shutdown of the firm for six months might cause another Rs.3,60,0001oss.This
Rs. 6,60,000 loss might force the firm to shut its doors, an action that would result in any
ultimate loss of the difference between the going-concern value of the business, say
Rs. 24,00,000 and the value for which the remaining assets could be sold, say Rs. 15,00,000
causing a Rs. 9,00,000 loss.
Loss severity also depends upon the number of units involved in the loss. For example, if
a firm t warehouses, one fire may cause considerable damage at all three warehouses.
has
Finally, in estimating loss severity, it is important to recognize the timing of any losses as
there
adjacen well as their total amount. For example, a loss of Rs. 5,000 a year for 20 years is not as
severe as an immediate loss of Rs. 10,00,000 because of
78
Unit 5
Risk Measurement
1)
the time value of money, which can be recognized by discounting future losses at
some assumed interest rate, and
2)
the ability of the firm to spread the cash outlay over a longer period.
Âctivity E;
M/s. Raj is a manufacture of a Motor car and recently receives an order for export.
Suddenly a strike is declared in his company. Note the number of losses he suffers due to
this situation.
5.7 BENEFITS OF MEASURES

Loss-frequency and loss-severity data do more than identify the important losses. They are
also extremely useful in determining the best way or ways to handle an exposure to loss.
For example, the average loss frequency times the average loss severity equals the total
dollar losses expected in an average year. These average losses can be compared with the
premium the firm would have to pay an insurer for complete or partial protection. The
variation (or estimated risk) in a loss frequency and loss severity sheds light on the
predictability of the losses and how serious the losses might be in a bad year.
Probability category may be higher. On the other hand, the probability that all of those
units will suffer the same type of loss from the single perils will be lower and may move into a
lower category. Given all the combinations of units, types of losses, and perils that are
possible, the number of probabilities that could be estimated is extremely large. Not all
these probabilities are worth the time and efforts involved in estimating a probability category.
Once the Risk Manager has determined what probabilities are most useful in decision
naking, however, if more precise information is not available, he or she can use Prouty's
our categories or some similar approach.
.8 LOSS SEVERITY MEASURES
When developing a risk management program, the Risk Manager must have a good idea )
( maximum possible loss and the maximum probable loss and these two measures
ommonly used to measure loss severity :
1)
The maximum possible loss to one unit per occurrence and
2)
The maximum probable loss to one unit per occurrence.
For the moment, we will concentrate on occurrences causing only one type of loss. The
maximum possible loss is the worst loss that could possibly happen; i.e. the total amount
of financial harm a given loss could cause under the worst circumstances. The maximum
probable loss is the most likely maximum amount of damage a peril may cause under
average circumstances therefore, is usually less than the maximum possible loss.
A worse loss could occur but the chance of its occurrence is less than some percentage
selected by the Risk Manager, such as once every 40 years. Because different Risk
Managers may select different percentages, they may disagree on the value of the maximum
probable loss even though they estimate the probability distribution to be the same. Of
these two measures, the maximum probable loss is the most difficult to estimate but also
the most useful and valuable risk management exercise.
In a recent article, Alan Friedlander suggested four measures of physical damage losses
due to fire per building per occurrence. The 1.
"Normal loss expectancy" is the monetary loss expected from a single fire when
both private and public protection systems are operative.
Example: At the time of fire, both automatic sprinkler etc of a firm and fire brigade of
the government is in operation.
2.
"Probable maximum loss" is the monetary loss expected from a single fire when a
critical part of the protection system such as an automatic sprinkler is out of service
or ineffective.
Example: Private protection system such as sprinkler installation system, smoke
detector etc is not in service or inactive and only fire brigade is there at the time of fire
3.
"Maximum foreseeable loss" is the dollar loss expected when none of the private
protection system is functioning. The fire in this case would probably burn until stopped
by a fire wall, until it burns all its fuel, or until the public fire department, summoned by
an outsider, arrives.
Example: In high sea there is a fire to natural gas plant and it burns until it stopped by
department of government.
4.
UnitS
"Maximum possible loss" is the loss expected from a fire when all private and
public protection systems are inoperative or ineffective.
Risk Measurement
Generally, the probability of the occurrence declines as we move from the normal loss
expectancy to the maximum possible loss. The four values depend upon innumerable
factors such as construction, occupancy, private protection, and public protection.
In estimating the maximum possible loss and maximum probable loss the risk manager,
ideally, would take broad view of problem consider all types of direct and indirect losses
that might result from a given peril and to make a plans to overcome the problem.
Fire loss potentials, for example, would include the possibly of net income and also recognize
that, though the probability may be low, more than one unit may be involved in a single
occurrence, thus causing the loss potential to increase. The probability is high, for example,
that a building and its contents will be damaged in the same occurrence.
To avoid the loss to take a shape of maximum potential loss, emergency planning must be
there. Some disasters require quick action such chemical and gas leakage, explosions etc.
The Union Carbide chemical leak in December 1984 is the best example of it.
Âctivity F:
What is the difference between maximum possible loss and maximum probable loss.
5.9 MAXIMUM PROBABLE LOSS (M.P.L.) ESTIMATION - PROPERTY

LOSS
_______________________________________________________________
For illustration in the estimation of Maximum Probable loss likely to affect Property, the
following are considered:
Factors to be Considered
The following factors should be taken into account when assessing maximum probable
loss:
1. Size, height and shape of area potentially exposed to a single fire or explosion.
2. Construction of roof, walls and floors.
3. Presence of combustible linings to walls, roofs, ceilings and partitions.
4.
Nature, distribution and combustibility of contents (fire load).
5.
Use of hazardous processes and substances and their degree of separation.
6.
Susceptibility of contents of damage by smoke heat and water.
7.
Risk of explosion from any source.
8.
Hazards arising from gases or corrosive materials.
9.
Concentration of values within a small area.
10. Standards of Management and housekeeping.

It would appropriate in some cases for the total M.P.L. to be built up from separate
assessments on -
Buildings
Machinery and other contents
Stocks particularly where the contents have low salvage value or highly susceptible
to damage.
s
In view of the many permutations of the factors mentioned above, which can apply to
different risks and their varying relevance to different risks, it is not practicable to relate a
'value' to each factor or the combination of factors.
^ Ac ti vit y G;
Suppose you are a Risk Manager of a chemical Factory and assign a job to calculate
Maximum Probable Loss. List out the points to be considered while arriving at the
estimate of loss.
Factors which should not be considered

However, the following factors should not be taken into account when assessing maximum
probable loss.
1.
Any horizontal separations
2.
Fire resisting doors
Unit 5
Risk Measurement
3. . The absence of any normal source of ignition.

4.
The extinguishment arrangements including sprinklers and the adequacy or otherwise
of fire brigade facilities.

5.10 SUMMARY______________________________________________________
In this unit we have discussed that all individuals and firms face uncertainties caused by the
possibility of loss. Arisk Management program is begins with identification and measurement
of exposures to loss.
The identification process begins with the recognition of four categories of losses:
Direct losses of property, such as loss of a machine in a fire.
Indirect losses, such as loss of income due to most important machine burnt and
production stopped.
Liability losses, such as Third Party injury or death.
Loss of key personnel, such as loss of a research scientist.
[n this unit we have seen how the estimate of loss frequency and loss severity helps in
taking the sensible risk handling decision. The evaluation of maximum possible loss and
maximum probable loss necessitates a careful study of the all types of injuries or damages
that may arise out of the organization's activities and of the law including recent court
awards. To arrive at sensible decision the data must be collected, collated, analyzed and
the results interpreted. Once the maximum potential for loss is estimated, the risk manager
can develop an integrated plan to deal with it.
5.11 KEY WORDS
Loss Frequency
It is the number of losses that will occur during a specific

period of time.
Seventy
The financial extent of impact ofeacn loss.
Probability
Most likely.
Maximum possible loss
It is a loss expected from a fire in all private and public

protection systems are inoperative or ineffective.
vlaximum probable loss
It is the loss due to fire after loss prevention and loss

reduction actions have been applied.
84
5.12 SELF-ASSESSMENT QUESIONS
1. How the risk handling decisions depends upon loss frequency and severity of
losses?
2.
Explain "severity of loss is the major factor to be taken into account while
evaluatiing
risk."
3.
How are exposures catagorised?
4.
Differciate between probable maximum loss and maximum possible loss.
5.
List out the factors taken into account while calculating maximum probable
loss which
affect property.
5.13 ANNEXURE_________________________________________________
^ _
RISK ASSESSMENT - GENERAL
CONSIDERATIONS FOR CONSTRUCTION INDUSTRY
As we have seen Risk identification and quantification are the initial steps towards
treatment of Risks. We now present an assessment questionnaire for a
specific industry -Construction Industry.
Following are the main considerations in risk assessment for construction
industry:
a)
Physical hazards of methods of construction
b)
Operational testing and commissioning
c)
Types of constructional plant and equipment
Consider the following examples and hazards, as they relate to a normal building
contract:
Excavation and de-watering (collapse of sides)
welding (fire or explosion)
Design work (which can increase the hazard)
concreting in low temperatures (frost)
Use of jib cranes for heavy loads, or in soft ground conditions (over balancing
impact
)
Partly completed work (storm or collapse)
Unit 5
Risk Measurement
Prefabricated concrete or cladding (impact)
Buildings with no separation (fire)
Tower cranes (collapse)
Work near to water (flood)
Work in remote areas (aggravated damage and higher reinstatement cost)
Structures supported by insecure foundations (subsidence, collapse)
Work in hazardous areas i.e. extension of chemical works (explosion, fire)
You will see that the hazards are numerous and can arise at any time during the construction
period, from many directions, and with varying degrees of damage resulting. It is therefore
difficult for the underwriter to assess. Remember that these are only a few of the broader
issues and each stage of the construction process brings its own specific problems.
Let us look at some of them :
Causes of Loss or Damage
These can be divided into broad groups:
Acts of God or Act of man, or a combination of both
Seasonal
Intentional or unintentional
Sudden or gradual
Continuing or intermittent
Mechanical, electrical or chemical
Initial, intermediate or immediate
vlore specifically
Fire
7.
Frost
Explosion
8.
Seasonal changes
Subsidence, heave, landslip

9.
collapse, vibration or undermining
Falls, impact, over balancing risks
8
5
4.
Earthquake
5.
Water damage
6.
Winds
DESIGN
Rfi
10.
Grime risk
11.
Riot, civil commotion, malicious damage
12.
Breakdown
Design also plays a critical role in the evaluation of construction risk. The questions
which are addressed whether the design is standard one or prototype.
Contractor' familiarity with the design.
Design of temporary works
ects
The third party risk can arise in respect of property and persons within the contract
site e.g. visitors such as the Employers, architects, surveyors and employees of other
contractors on site. It also arises in respect of persons and property outside the contract
site. Here the risk is to persons passing by the site, and to adjoining property.
c
.
Damage to underground services is a common occurrence and if great concern

to underwriters with the recent appearance of fibre optic cables which are extremely
expensive to replace.
T
h
i
Some of the particular liability hazards are:
The use or proximity to inflammable substances;
Dangerous chemicals;
Fragile or valuable machinery, either used or erected;
Valuable feedstock (during testing and commissioning);
Spreading fire to adjoining property, with consequential loss of trade, and

possible
injury;
cutting the supply of utilities to adjoining properties i.e. gas, water, electricity.
The
risk may only result in pure economic loss but if damage is caused to the third
party's
own property. Liability for the consequence of that damage may be actionable.
Collapse of own or hired plant;
t
y
A
s
p
Unit 5
Risk Measurement
Pollution risk (work on petro-chemical, or similar risks) which can take many forms.
Underwriter will not cater for claims arising from deliberate or uncontrolled discharge
ofpollutants;
Design risks, or defective workmanship;
The various disciplines on a site e.g. excavation
dewatering;
piling;
use of explosives;
tunnelling;
underpinning;
welding;
use of plant;
laying of pipes and cables in built up areas;
operational testing and commissioning
The Construction Process
Following factors help in evaluating the process relating to risk:
Demolition
Earthmoving
Mass excavation
Trenching
Shaft sinking
Pilling
Foundations 1. Weight of the structure
2
Moisture changes in the ground
3.
Insufficient compactness of the ground
4.
General movement
System Building 1.
Size and value of their largest components
2.
Actual method of erection
3.
Fire
4.
Method of Storing major component parts
5.
Height of high-rise building
6.
Location of the temporary factory
7.
Transit
Steel Framed Building
1.
Building utilising high alumina Cement
2.
Tall Buildings
Operational Testing and Commissioning

s
Main hazards are -
Breakdown of large generators;
Mixers e.g. in plastic and rubber factories;
Heavy presses (Motor industry, board manufacture and other heavy industries)
Iron ore crushers
Explosion of black liquor boilers (pulp works)
Fire and explosion following introduction of feedstock in oil refineries and petro
chemical plants.
Review
i.
Use some of the graphs in Appendix of Chapter HI to explain the concepts of frequency
and severity of Fire losses of Indian insurance industry, ii.
With the data of loss
frequency and loss severity how the risk Manager takes a

proper decision to identify the exposure of a firm? m
Maximum Possible Loss. Which factors are taken into account
and which are not, in measuring MPL?
Unit 5
Risk Measurement
NOTES
Explain the concept of
6.1 INTRODUCTION
So far in the previous units we have seen the meanings of terms like Risk, Hazard etc.
Now we will try to learn the meaning of the word exposure.
The term 'exposure' indicates the extent of potential for a loss.
In an earlier unit we had come across the concept of Probable Maximum Loss or Estimated
Maximum Loss. Exposure in fact is close to this concept. By identifying and measuring the
potential for exposure, we designate the extent of risk which is faced in a particular
contingency, in respect of a particular property or liability.
We will now discuss regarding different types of categories which is exposed to the losses
as follows:
1)
Exposures of property
2)
Liability exposures
3)
Revenue exposures
4)
Interest exposures
First we will see exposure to property
6.2 EXPOSURES OF PROPERTY

By property we mean tangible assets either of
1.
Personal nature or
2.
Commercial nature.
Property can also be broadly classified into movable and immovable property. When we
say tangible, what we mean is that the property should be physically present and identifiable.
In contrast to tangible property, there are property or properties, which the accounting
convention would classify as assets for e.g., the Intellectual Property or Royalty or Goodwill
etc.
Property again can be belonging to an individual or belonging to a commercial organization,
leased from others or leased to others, property under construction or belonging to the
government and similar public enterprises. Examples of movable property could be
automobiles, finished goods of a factory. Examples of immovable property could be Fixed
Machinery, Building etc.
Unit 6
Exposures
6.3 TYPES OF EXPOSURES TO PROPERTY

Another term peculiar to Risk Management is "Peril". By "Peril", we mean a causative
factor. Perils normally trigger off a loss situation which affects tangible property and causes
either loss or damage to such property. For instance Terrorism is a peril. Perils again can
be broadly classified into physical, human, economic.
Physical perils: The examples are causes like fire, explosion, flood.
Human perils: The examples are causes like negligence, riots strikes.
Economic perils: The examples are recession, inflation, change of government, stock of
finished goods becoming unfashionable or absolute.
Though Risk Management largely is concerned about human and physical perils, of late
economic perils are also getting a high level of attention.
The Valuation of Potential Property Losses
Risk Manager must place a value on potential losses. Such value may be measured by:
1.
Its replacement cost or current purchase price.

Calculating the exact property value is difficult in case where the replacement cost is
unrelated to accounting book value. If the property is destroyed, the actual cash
value is a better measure of the exposure.
2.
Its current resale value or net realizable value.
3.
The net present value of its expected future earnings.
Usually current asset can be valued at their replacement cost (mainly cash, negotiable
securities, stock of raw materials)
Âctivity A:
Comment on "In an inflationary economy, replacement cost at the time of future loss may
not be the same as current replacement cost."
6.4 LIABILITY EXPOSURES

The term 'Liability' indicates in a very rudimentary manner, 'responsibility' - Which is
responsibility to one's partners, employees, family members, the society and the public at
large. This kind of responsibility to others can arise out of certain laws, regulations or be
out of even common law or convention. Or it can arise out of even certain agreements or
contacts entered into by various parties.
6.5 LEGAL LIABILITIES_______________________________________________
It can be broadly classified into civil and criminal liabilities.
Civil Liability:
Though the dividing line between civil and criminal is quite often a thin one, it will be useful
to know that civil liabilities normally result in compensation to the affected party. You
would have come across in Newspapers, of the various levels of Consumer Forums set
up by the government. These forums provide redressal to consumers whq are aggrieved
at the action or inaction of certain product or service suppliers. The exposure to such
suppliers will be out of causes like deficiency in service, delay in compliance and so on. If
the Consumers Forum finds out that a particular supplier was deficient in service then they
may award a monetary compensation to be paid by the erring organisation to the affected
individual.
Criminal Liability:
As against this criminal wrongs result in some kind of a punishment to ensure that such
crimes do not get repeated. An assault by one individual on another attracts criminal
punishment, and the individual who had resorted to assault could be either imprisoned or
a hefty fine imposed on him.
The Law of Torts is concerned with civil liability other than those arising out of breach of
a contract. Normally a prudent person is expected not to commit certain acts or alternatively
do certain things as society would expect of him. The non-adherence to these can result in
civil liability.
Think of a family residing in a high-rise building of about 35 storeys, (this family can be
residing in the 20th storey). If a flower pot kept in the balcony of their apartment happens
to fall on a pedestrian on the road below and injures him, the family can suffer a civil
liability arising out of negligence. Similarly if a trader contracts to supply certain type of
Unit 6
Exposures
goods in certain time and certain price to a customer and defaults either in time or in quality
of goods promised, there can be a breach of contract and the contract provisions may
either provide for penalties or penalties can be invoked under the Law of Contracts.
Individuals, families, business can therefore face a variety of legal liabilities.
Âctivity B :
Write down two examples each in case of civil as well as criminal liability.
Nowadays various liability losses are increasing due to increasing awareness of the society
towards its rights such as product liability, public liability, professional indemnity, liability of
workmen's and environmental liability.
Now we will discuss it in detail.
6.6 PROFESSIONAL LIABILITY

Professionals like doctors, lawyers, accountants, architects can also face liabilities arising
out of their professional practices. The legal liability is pay damages arising out of negligence
in the performance of their professional duties. It is classified into two categories:
1.
Professional negligence may result in bodily injuries (fatal or otherwise)

Doctors, Dentist fall into this category
2.
Professional negligence may result in financial loss.

Chartered Accountants, Architect, Solicitors fall into this category.
Loss resulting from bodily injury or death cannot be measured in terms of money. Hence
calculation of liability depends upon number of factors such as age of the claimant, earning
capacity, nature of injury, etc.
Medical malpractice is a major concern in developed countries and without adequate
(ftsusasvcc a:g^sVs\\cM\?to&\ks, iUsNirtttafty/ impossible for medical practitioners to pursue
their profession in these countries.
Loss in the second category can be measured with more certainty as it involves actual
financial loss sustained by the client.
Firm of Auditors were held liable for breach of contract in failing to complete certificate
correctly. The client had to submit annual certificate of actual gross revenue earned. The
auditors made a mistake in the figures certified with a result the client suffered a loss and
due to this a liability arises.
Â ct ivi ty C :
An architect fails to prepare plans and specification as per desired standard for a commercial
complex. Write down the liability arises in this case.
6.7 PRODUCT LIABILITY

Product liability arises for death, bodily injury or illness caused by poison or other
deleterious matter in the manufactured / supplied / treated / food, drink or other products,
damage to property caused by any goods manufactured / supplied / treated / sold / repaired
/ altered / serviced from/in the country and accident occurred outside the insured's place
or premises.
Increasingly strict laws and court decisions favoring injured parties, emphasize the
importance of this problem.
The claims of liability increases because of the wide variety of product e.g. canned food
stuff, aerated water, medicines and injections, animal and poultry feeding stuff, electrical
appliances, mechanical equipments, acids and chemicals gas cylinders etc. manufactured
and sold to the public and if defective may cause death injury or property damage.
Unit 6
Exposures
Âctivity D;
A defect in a batch of injections and capsules results in a injuries to a large number of
people. Enumerate the liability arises due to this incidence.
6.8 PUBLIC LIABILITY_______________________________________________

Public liability arises due to accidental bodily injury or damage to the property of any
member of the society. It covers liability arises due to either breach of contract, from a tort
or from liabilities imposed by status.
The liability arises in public liability divided into three categories as follows:
Public liability due to Non Industrial risk: Hotels, Cinema Halls, Schools, Film studios,
Godown, Shops, Tank farms, etc.
Public liability due to Industrial risk: liability arises due to industrial and storage risks depots,
warehouses, etc.
Compulsory public liability: in this case liability arises due to handling of any hazardous
substance which results into death or bodily injury to any person or damage to property of
any person.
According to Public Liability Act 1991 imposes fault liability i.e. irrespective of any wrongful
act, neglect or default on the owner to pay the relief and as per act this liability shall be
compulsorily insured. The reason is because growth of hazardous industries, processes
and operations in India the number of accidents increases and ti give minimum relief which
is based on "no fault" liability.
.Âctivity E:
Explain "As per Public Liability Act, 1991 the liability shall be compulsory insured."
98
6.9 ENVIRONMENTAL LIABILITY

Society has become increasingly aware of the damage and injury caused by the
release of contaminants into air and the disposal of industrial waste on land and
into water courses. Similarly there are serious concerns on the manufacturing
company's responsibilities towards the environment. Firms engaging in
production or storage of hazardous substances are required by law to be
responsible for any loss or damage to life or property of others.
Business, firms, and municipalities recognize significant liability exposures from
their past and current operations. Business firms are responsible for creating
obnoxious level of heat, noise or vibrations. Waste disposal is the source of
many problems for the society. Each of these pollution problems can lead to
lengthy litigation and extremely large liability losses.
The risk Manager should provide the most efficient solution for this growing
problem.
Remember the Bhopal gas tragedy that occurred in 1984. Even the Managing
Director of the parent American company which owned Union Carbide in India has
been held personally responsible for negligence. While Union Carbide is expected
to provide compensation to the victims, their Chairman at that time, faces
criminal proceedings.
xgTActivity E:
Being a Risk Manager of a paper factory, find a solution for polluted water
which is generated in the pulp process.
6.10 EMPLOYRE'S LIABLITY
Employer's liability arises under common law or statutory law to pay

compensation to his employees for 'occupational' accidents or illness. Due to
industrialization the number of accidents results into death or bodily injury
increases and to give protection to the employee the act was passed.
According to Workmen's Compensation Act, 1923, employer is liable to pay
compensation to the employee in respect of death or injury or disease arising out
of and in the course of employment.
Unit 6
Exposures
Âctivity H;
Why is the quick resumption of operation a problem for some business? Give examples to
explain your answer.
6.12 INTEREST, WHICH CAN HAVE EXPOSURES

We have had a brief overview of the kind of exposures an individual or a firm can face.
Now we will proceed to analyze who effectively can have this kind of exposures.
)wners of the Asset
Basically anybody who has financial interest in the continued survival or performance
of .ny asset will have the exposure in respect of the asset. Hence those who have
ownership
iterest in the asset will be the ones who will be directly affected by any loss or damage
to .. ie asset or property. If a large commercial shopping center is owned by any individual
or
firm, any loss or damage to such property will primarily affect such owners.
I inance Parties
ot all assets are acquired or built up by using only the funds of the owners. Quite often
cause of the size of investment involved, the financial institutions step in and they lend
oney to individuals as well as promoters of projects for building up the assets. It is
ramon practice now to borrow money from banks and similar financial institutions to
quire assets even a personal nature like two wheelers, cars, houses etc. Similarly large
estments say e.g. in building up infrastructure projects like roads, or bridges also require
bstantial investments which cannot obviously come from just few individuals. In this
case also the lending institutions come into play and offer either loans or similar forms of
"lancial assistance to the promoters to help them put up these projects.
In ail such cases where institutions have invested or have lent money they too have a
financial stake in the continued survival and success of such ventures. Either during the
o instruction or during the operations if any loss or damage takes place to the assets so
' eloped, with institutional help, then these institutions also are likely to lose their investments
; there are serious interruptions to the business to which the finances are provided, then
in?
the repaying capacity of the borrowing entity might also get affected resulting in
default of loans or interest payments etc. Therefore the financial institutions which
have assisted such individual or commercial acquisitions do have an interest and
a corresponding exposure on these assets.
Contracted Parties
In the example of the commercial complex cited above, it is not only the owners
who have financial interests. When such a complex is put up it is obvious that it will
require a sufficient level of occupancy of the various floor spaces being offered.
The occupants also have stakes in the survival of the commercial complex. If any
major catastrophe takes place the occupants are bound to lose, as their business
operations cannot continue. Moreover any rent they may have either paid or
supposed to pay, depending upon the terms of the rental agreement, may also
have to be forgone. In such cases these kinds of tenants or similar persons who
have a contractual relationship with the owners of the asset also carry the
exposures in respect of the asset.
Âctivity I:
Bank has financed a big project of chemical factory. Unfortunately one unit
burnt due to fire and production stopped. Enumerate the various exposures
involved in this case.
6.13 SUMMARY____________________________________________________
In this unit we have introduced the concept of exposure. Different types of
property can be affected by physical, human or economical perils. In this unit we
have also discussed how liability arises in civil and criminal cases. Due to
increase awareness in the society different types of exposures arises like
Professional liability, Product liability, Employer's liability, etc.
We have discussed in detail the liabilities arises due to revenue exposures. There
are direct and indirect losses have to bear to continue the operations of the
business firms.
We have also discussed that owner of the property, Financer, contracted parties
are also affected due to exposure of various kinds.
Lnit 6
Exposures
6.14 KEYWORDS
Exposure
The extent of potential loss.
Peril
A causative factor. Perils normally trigger off a loss situation,

which affects tangible property and causes either loss or
damage to such property.
Liability
Responsibility
Civil Liabilities
It normally results in compensation to the affected party.
Criminal Liability
It results in some kind of a punishment to ensure that such

crimes do not get repeated.
Professional Liability : The legal liability is pay damages arising out of negligence in
the performance of their professional duties.
Product Liability
: It arises for death, bodily injury or illness caused by poison or

use of defective product.
Public Liability
: It covers liability arises due to either breach of contract, from

a tort or from liabilities imposed by status.
Employers Liability
: It is to pay compensation to the employees for 'occupational'

accidents or illness.

i.
How are exposures categorized?
ii.
Identify some perils in the Property Exposures.

In the case of a textile mill which is located on leased land and which has: Loans from
commercial banks for capital; borrowings from Textile Development Council for
Machinery up-gradation; Advances from buyers for fabrics; Enumerate the Exposures
of various parties in respect of the various assets of the Mills.
iii. Give a note on Liability Exposure. Give two examples for each liability.
iv. Sometimes indirect losses are more than direct losses. Enumerate this state with
examples.
7.1 INTRODUCTION
So far you have seen the process of Risk Identification, Risk Measurement. We shall now
learn about the various methods and tools which are available for managing the risk so
identified and measured.
From olden days men have been searching and developing ways and means of controlling
and managing the risk being encountered for their safety, survival and success, various
methods are developed. In the process of risk management risk control is a major part.
Risk control consists of three elements. Those are
1.
Risk Avoidance.
2.
Risk Reduction.
3.
Loss Control.
In this unit we will discuss about these elements in details.

Risk is an unavoidable fact of life. We cannot get anywhere if we avoid taking risk.
7.2 AVOIDANCE______________________________________________________
Sometimes the best method of dealing with an exposure to loss is to avoid all possibilities
of the loss occurring. A successful risk avoidance results in the total elimination of exposure
to loss due to a specific risk. Sometimes to avoid risk means abandoning some activity
and losing some benefits accompanying it.
Sometimes risks are unavoidable. For example, the risk of bankruptcy, the risk of liability
suit, or the risk of premature death cannot be avoided by the firms or individuals. The
exposure to loss can often be reduced but not eliminated. For other exposures, avoidance
is the only reasonable alternative.
When the chance of loss is high and loss severity is also high, avoidance is the best and
sometimes the only practical alternative. Risk avoidance means the chance of loss has
been eliminated. In practice it means not introducing new product, ending the production
of an exiting product, discontinuing some operations or selecting a particular peril where a
particular peril is not available.
When there is a significant chance of death or disablement, individual avoid such choice of
careers. If there is chance of financial failure, people generally avoid such business.
Businessmen avoid investing in some countries where there is always labour unrest.
Unit 7
Risk Control -1
7.3 WAYS OF AVOIDING RISK

One way to control pure risk is to avoid the property, person, activity with which the
exposure is associated by
1.
Declining to assume the exposure
2.
By abandoning an exposure which is already present.
Let us look at an example for the declinature part. If a geographical area is known to be
highly earthquake prone then a firm which would like to expand its business activities in
such a zone can simply avoid building any business unit there so as to avoid the severity of
any possible earthquake. Similarly, an individual who is not having a bank safety locker
facility can think twice over acquiring expensive jewellery which is prone to theft. On the
liability front, a firm which is engaged in manufacture of general pharmaceuticals can avoid
any investment in pesticides or insecticides producing plants if it considers, the liability
exposure due to any leak in such plants is too severe for it to handle.
Now let us look at avoidance through the process of abandonment. If the exposure due to
an asset or a liability is of such a nature that it poses continuous financial implications for
the firm, then the firm as well can choose to abandon the asset and avoid the exposure
associated with the risk altogether.
For instance if a boiler and pressure vessel plant situated inside a factory has become
substantially old and it has been found that it can cause possible leak of gas or air due to its
poor condition, then the firm which utilizes it can as well replace this boiler with a new one.
Similarly if a manufacturing process is found to produce qualitatively defective products
on a continuous basis then the manufacturing firm can give up the process in favour of a
better process; otherwise the defective products might result in liability exposures related
to the quality of the product. Similarly parents who have very adventurous teenage children
can avoid the exposures due to automobile accidents by selling their fast and expensive
car. Though avoidance as a risk control tool, on the face of it looks to be very simple to
adopt, in practice it is seldom so.
There are three main reasons which make avoidance a complex issue.
I. Avoidance by itself may sometimes be impossible. The airline business is full of risks.
There are exposures of the aircraft crashing, there are exposures of cargo getting
lost, there are exposures of hijack etc. But to avoid these entire risks one cannot
even dream of avoiding air travel - The world is so much networked today through
air travel that it will be impossible for avoiding investments in aviation.
108
2.
That brings us to the fact that sometimes there is an exposure associated

with an
asset or an activity can in fact be for out weighed by the benefits such
assets or
activity can bring about to the society. The Euro tunnel which links mainland
Europe
with United Kingdom is a submarine tunnel which has made the travel
between these
two areas such a convenience that any exposures which could be
associated with
such under the water structure is not sufficient reason to avoid building such a
structure.
3.
Sometimes even avoidance of one type of exposure can lead to creation of

another.
It is quite a common practice nowadays for large corporations particularly in
the Fast
Moving Consumer Goods industry to get their manufacturing done by third
parties.
This type of contract manufacturing facilitates them to avoid problems
related to
labour unions as also enable them to save costs significantly. But having
avoided such
exposures the new exposures of the quality considerations as well as
Business
Interruption and viability of the business of contractor is added to the list of
exposures
of the original corporation.
Any person involved in the process of risk mapping and management will
necessarily have to identify measure and then analyse risk which necessarily
had to be avoided. But as mentioned earlier this is a very complex exercise
which involves inputs from all other sections of an enterprise.
To realize the complexity think of this: when the famous Shanmukanandha
Auditorium in Mumbai was devastated in a major fire few years back it took the
resolve and opportunity evaluation by the managing committee to reconstruct the
edifice in its previous place and restore its old glory. This was perhaps a
simpler decision when compared to the big dilemma facing the New York
Port Trust who are the original owners of the ground on which the World Trade
Centre Towers were built. The issue before New York Port Trust is whether at all
a similar sky scraper built in the area which will again stand exposed to the kind of
attacks by terrorist on 11th September. This is a classic avoidance issue.
Âctivity A;
Give
two
examples of risk avoidance where you have lost the benefits accompanying it.
Unit 7
Risk Control -1
7.4 THE COST OF RISK AVOIDANCE

Sometimes it may be possible to avoid risk without any undue difficulty or exposure, but it
is never costless.
1.
They may be monetary costs (such as additional bank charges for paying wages by
credit transfer to avoid the risk of paying in cash) or opportunity costs (such as the
income forgone by abandoning the production of a certain hazardous product).
2.
They can be direct or indirect costs. The changeover to payment of wages by credit
transfer, the extra bank charges would be the direct costs and indirect costs may be
incurred in having to increase wages to overcome opposition from employees to the
new system of payment.
7.5 RISK CONTROL: LOSS CONTROL & LOSS PREVENTION

Loss control is another major step in Risk Management. Loss control measures are aimed
at either lowering the chance or probability that a particular type of loss will occur or if it
occurs reduce its severity and impact. In contrast to loss avoidance which eliminates the
risk but forces the firm to avoid or discontinue the activity. Loss control measures have
unique ability to prevent or reduce losses and enable the firm to continue.
Loss Prevention programs seeks to reduce or eliminate the chance of loss whereas the
Loss reduction programs seek to reduce severity of the loss. But sometimes there will be
an overlap that some loss control programs double up as both loss prevention and loss
reduction programs.
7.6 LOSS PREVENTION
There are a variety of ways in which losses can be prevented from happening either totally
or the chances of loss occurring can be reduced significantly. Thus successful loss prevention
activities lower the frequency of loss. If the benefits derived from loss prevention exceeds
the cost, it is useful.
Large industrialist often employs safety engineers at the time of construction to identify
sources of loss or injury and apply preventive measures and safety devices so to reduce
the chances of losses and accident.
One major concern in human safety in factories is the accidental injury to workman.
Particularly in construction industry sites workers are required to work in very hazardous
conditions. Either it could be working at a great height by using unsafe support systems or
even at the ground level it would mean working with heavy equipment like excavators and
bulldozers. By providing a proper scaffolding and support system for access to higher
levels of construction, the workers getting injury due to fall can be reduced or totally
eliminated. Similarly by providing safety meshes around moving equipment, accidents to
workers can be either totally prevented or minimized.
Some losses are due to environmental hazard such as poor layout of machine, inadequate
light or ventilation, inadequate smoke detector or insufficient fire fighting equipment. Some
losses are related to human shortcomings and errors such as bad judgment, inadequate
training, supervision or lack of attention to safety requirement. Good safety programs can
be developed and implemented to deal with these situations.
Concerns on individual safety have forced governments all over the world to enact legislation
to make it compulsory to have seat belts in automobiles as well as ensure two wheeler
riders wear safety helmets. Fire accidents in textile mills where a huge amount of waste
collects or deposits itself in and around electric equipment and points of ignition can be
prevented by installing fire and smoke detectors as well as having sprinkler systems. These
systems ensure timely detection of any increase in temperature or presence of smoke and
activate the sprinkler which will douse the area where detection has taken place with
appropriate fire extinguishing agent like water or carbon dioxide.
Other examples of loss prevention activities include use of safety guards on saw blades,
security guards in banks, drive training and safety education programs, warning printed on
drugs and dangerous chemicals.
Similarly ports have cyclone warning information systems with the help of which they are
able to alert the incoming and outgoing vessels about an impending cyclone or weather
disturbance. However in spite of all this early warning systems, accidents do occur,
exposures do get materialized and a loss results,.
Many loss prevention measures reduce death or injuries, establishing engineering solutions
or using cost benefit analysis. After taking all above precautions some accidents occurs,
this takes us to next aspect of loss control, namely, Loss Reduction.
Unit 7
Risk Control -1
>gf Activity B :
What preventive measures you will take at the time of construction of a high rise building.
7.7 LOSS REDUCTION
As the name implies Loss Reduction aims at reducing or mitigating the impact and
extent of a loss event. Once a loss triggers off either during the course of a loss
occurrence or immediately after it, several measures can be taken which can bring
about reduction in the severity of the loss event.
Loss minimization programmes are a type of loss reduction programmes. These aim
at reducing the extent of loss or transfer the loss actually happening. The other types
of loss reduction programmes are called as salvage programmes. These take place
after the loss has happened and ceased to continue.
To get an idea of loss minimization programmes, think of a huge volume of garments
which is meant for exports and which is stored in a large warehouse. If this warehouse
happens to be located in a low lying area and if there are heavy rains which flood the
location and the flood waters rise to such a level within the warehouse then most of the
stored garments will be affected by flood water damage. If the garments owner was
aware of the potential for flooding then he would have taken adequate care to store the
garments well above the ground level on specially designed racks so that the flood
water could not have reached the bottom layers of the garment stacking. However
having been affected by the flood waters entry, the best way to reduce the loss or
minimize the loss is to make sure that these garments, particularly the affected ones are
removed to a properly elevated place of safety, dried there, washed there and any textile
processing method which can restore the quality if available should be used.
In
case
all
these
metho
ds do
not result in restoring the pre lost quality of the fabrics then they may not be fit for
exports or even sale as new. Then comes the question of further loss reduction by
salvaging efforts. If the garments after proper cleansing and finishing can be sold as
'seconds' there could be a fair amount of realisation of the original price. This
realisation then would reduce the impact of the loss as compared to the total rejection
of these garments.
In the same manner we find that automobiles which meet with major accidents are also
recovered and then, because they cannot be reconditioned or repaired they are sold as
scrap. Specialist scrap buyers buy this kind of wreckages and they cannibalise the damaged
vehicle to retrieve at least some parts which can be reconditioned and sold as 'seconds'.
In the developed world there are specialist Recovery companies who have developed
expertise in salvaging and recycling goods and commodities of any type.
Salvaging also has a special meaning in the realm of Maritime Trade. There are frequent
casualties on the high seas and the Inland Water ways and Port premises in which ocean
going vessels or other type of waterborne vessels get affected due to various types of
perils and then sink. Such casualties not only result in financial loss to the owners of the
ship or vessel but also they sometimes block ocean ways or port areas preventing the
maritime transit. Again there are specialist agencies like Salvage Corps, which help in
recovering the wreck and removing it to a designated place.
Loss reduction measures also can be classified as follows:
1.
preventative: eliminating the cause of loss.
2.
protective: protecting things or persons exposed to damage or injury.
3.
minimizing: to limit the loss as far as possible.
4.
salving: to preserve as much as possible of the value of damaged property or the

ability of injured persons.
V,
Examples of various measures :

Loss probability reducing measures: Fittings of safety guards to dangerous machinery,
removing potential sources of ignition, removal of obstacles, spillage and slippery surfaces
from gangways, stairs, etc. Separation of vehicular and pedestrian traffic.
Loss severity reducing measures : Storage of water susceptible goods above floor
level, installation of sprinkler systems and smoke vents, provision of first aid facility, fittings
of water tight compartments in the ship, fire walls and doors in the buildings.
Mixed measures: Replacement of combustible with fire resistant building material, limiting
stocks of explosives/combustible material, education to employees regarding hazard.
Training to employees in the form of first aid for personal injuries or protection of damaged
plant to prevent further is necessary to cut the losses.
Unit?
Risk Control -1
Another classification of risk reduction measures is as follows:
1.
Education and training
2.
Procedural devices
3.
Physical devises.
In brief we will see these measures
1.
Education and training: Courses in security, fire prevention, productivity security,

specialized courses for key staff.
2.
Procedural devices: Periodical conditions of safety devises, security petrol including

night watchman, inspection of premises before closure for evening or weekend,
effective internal audit system, stand by equipment, stocks and alternative sources of
power services.
3.
Physical devises: Venting of toxic and explosive fumes, separation of hazardous

process, and automatic switch off devices of machines if fault arises, safety guards,
valves, security locks, fire and burglary alarm with connection with police and fire
station, warning devices for leakage of gases and radioactive materials.
Âctivity C:
a)
Write down risk reduction measures for the cotton industry assuming that you are a
Risk Manager.
b) Suggest a method for reduction of loss due to cotton waste.
7.8 LOSS CONTROL TECHNIQUES

Loss Control Techniques normally are classified.
a.
Those with Engineering approach
b.
Those with Human Relation approach.
We will now understand 'The Domino Theory' proposed by H.W. Heinrich, a pioneer
in safety concepts. According to 'Domino Theory' a preventable accident has one of the
five factors in a sequence that results in an injury. The sequence is as follows:
1.
History and Social Environment
2.
Faults or the person (inherited or acquired faults of the person constituting approximate
reasons for committing unsafe acts or for the existence of mechanical or physical
hazards).
3.
Unsafe act and/or mechanical or physical hazard.
4.
Accidents
5.
Injury
>s
According to Heinrich, in accident control, the bull's eye of the target is the third step in the
sequence.
The Engineering approach traces emphasis on the mechanical or physical causes of
accidents. In reality there are numerous such causes. It could be a defective electrical
wiring which can spark off and ignite materials which can easily catch fire. It can be poor
braking system in a automobile which can lead to serious accidents. It can be lack of
proper lubrication in moving machinery parts which can lead to high levels of friction and
heat and result in jamming of equipment.
Examples can be numerous but the underlying phenomenon is one of either a defective
material, a defective design, defective workmanship or defective handling. It has however
to be remembered that neither the engineering approach nor the human approach can be
used in isolation of each other.
While Heinrich's Domino Theory still is acclaimed to have validity, a recent day expert,
Dan Petersen has added a sixth factor to Heinrich's sequence namely Management
Fault. According to him this is what primarily drives other five factors in motion. With
increasing sophistication in equipments and tools and equally increasing concern for human
safety, it is no wonder that Management's responsibility and accountability to ensure loss
prevention and minimisation has increased tremendously.
Unit?
Risk Control -1
Safety engineering has developed into an exclusive faculty by itself with the interdisciplinary
cross pollination of knowledge across Medical Sciences, Engineering Sciences, Information
Technology, Environmental Sciences have all blended and have contributed in the
development of safety engineering. While basic concerns remain the same, the access to
information across various disciplines has resulted in advanced methods of Loss prevention
and minimisation. Using the Engineering approach, there are techniques which we have
seen earlier like Hazard and Operability Studies, Fault Tree Technique, Root Cause Analysis
etc., these all provide predictive techniques involving the process, products and sequences.
Similarly starting from the Time and Motion study which was evolved in the mid forties to
the latest Psycho Biological tools have given immense scope for proper analysis from the
human safety point of view. Particularly after few major industrial disasters, Loss Prevention
and Human Safety plays a priority item on the agenda on any management. Many Industrial
undertakings either by regulation or as part of their social and corporate responsibility
have a dedicated safety department in their premises. With a result, practically every activity
of human endeavor currently has a state of the art Loss prevention and reduction
programmes available.
In summary, Loss prevention or Loss minimisation programmes aim to map the trigger
factors which can set in motion a loss sequence. They either attack this trigger points or if
after the trigger is set off they try to control the consequences through selective techniques.
These techniques comprise recycling, recoveries, alternate sources of production or supply,
relocation and similar tools. In the Annexure to this chapter there is a brief outline of
institution based in India which specializes in Loss Prevention, Education and Research
and Communication. Similarly there is another body called as National Safety Council
which also provides useful information on Safety practices to industries.
7.9 RISK CONTROL: SEPARATION, COMBINATION AND TRANSFER
Separation
reparation is a process of segregating a firm's exposure to various locations brought by
oncentrating them at one location. A tyre manufacturer who caters to the length and
>readth of the country can produce tyres at one single location and transport them to
arious convenient distribution centres all over the country. By such spreading of the
xposure to various locations, the chances of the stock of tyres getting affected in Fire
azard is limited to the quantity at any one location. Therefore, even if such an event
iappens in one of the locations the stock can be redistributed from other locations and
aereby the continuity of the supplies to the customers can be maintained.
116
Similar segregation techniques are used even in the layout of plants and
factories. In a large factory complex, there may be certain areas where
hazardous processes are being carried out or hazardous goods are being stored.
E.g. in textile factories there is a process called as 'singeing' whereby the fabric is
given a final finishing touch by running the fabric over a controlled flame. Such
process being hazardous by nature, the textile factory layouts normally separate
this process into an exclusive area and build what are called as 'perfect party
walls' between this area and the rest of the textile factory. Segregation in effect
uses the Law of Large Numbers by increasing the exposure units and thereby
enabling the firms to predict what its loss experience will be.
j$ Activity D :
Comment on "In separation of hazardous process perfect party walls plays an
important role."
Combination
In separation, a specified number of exposure units under the control of the
firm are relocated. In combination, the numbers of exposure units themselves are
being increased so that again the Law of Large Numbers comes into play and
then the chances of loss are reduced. We know that the larger the size of the
sample, the closer will be the probability of the loss to the underlying probability.
To illustrate this point think of an automobile company which owns 100
vehicles. If the underlying probability is that 1 out of every 25 vehicles will meet
with an accident in a year, if they so happen that for the 100 vehicles owned by
this company, it is not just that 4 vehicles i.e. 1/25 of 100 will only meet with
an accident. It may so happen that even 40 vehicles can meet with an accident if
the company is unfortunate. If the number of vehicles owned is increased from
100 to let us say 500 it may so happen that the underlying probability i.e. one
of 25 may closely apply to this sample. By increasing the number of exposure
units the firm is in a position to have a loss history closer to the underlying
probability.
On a similar basis if a company depends upon only 3 or 4 major suppliers for the
supply of its critical inputs then even if one or two of them suffer any problem
then the company
Unit 7
Risk Control -1
will be affected. On the other hand if the sourcing of supply is done from a large number of
suppliers then there is always a possibility of securing supplies from the alternate sources.
Diversification into many different products or services is another example of combination
technique. By diversifying, the business risk in one or few lines of business can always be
balanced by lesser business risks in some other activities.
Âctivity E;
a) List out the points for the given project taking into account loss control.
b) "In case of Dairy project alternative arrangement for water and power is of prime
importance."
Risk Transfer
One ultimate tool largely used in risk control is a process of Transfer of Risk. This type of
transfer can happen in many ways by we shall be looking at few of them in this chapter.
Purchasing of insurance is a major Risk Transfer activity, which we shall study, elaborately
in succeeding chapters. At the moment we will confine ourselves only to two methods
namely,
Transfer of activity that creates the Risk Control.
Transfer of the financial losses arising from the risk i.e. Risk Financing.
A) Transfer of Activity that creates the Risk Control:

There are number of advantages if specialists are appointed for hazardous task which
are as follows:
1. Being more experienced and skilled in a work, specialist can complete the work
more safely.
2.
The equipments can handled more easily by specialists than the principal as it
may prove uneconomical to the principal.
3.
Principal may avoid the difficulties and bad publicity due to accident by employing
sub-contractor or even mere carrying out the work itself may cause.
To understand Risk Transfer let us take the example of the major contract for building
a flyover being awarded to a large construction company. To execute this contract,
the construction company has to procure materials of construction, employ labour,
employ construction equipment and also arrange for proper and timely financing.
In each of these activities there is a certain amount of exposure and risk. In the case
of procurement of materials there are issues of quality, timely supply and costs. In the
case of employment of labour there are issues of availability of labour, problems of
trade unionism etc. as also injury to workers in construction site. Similarly even in the
case of use of construction equipments like bulldozers, excavators there are problems
of availability, maintenance of equipment, as well as accidental layoffs.
With so many risks associated with every type of activity in the construction process
this construction company has a very onerous task on its hand. If all these exposures
have to be handled by a construction company then it will be left with little time for the
core activity, namely, construction. Therefore the construction company can resort to
transfer of risk by subcontracting various activities listed above to different firms
specializing in each of these areas. Labour supply can be subcontracted to a Labour
supply firm and similarly construction equipment can be leased from a leasing firm.
By this process of subcontracting, the risks which could have been otherwise resting
with the construction company are now conveniently transferred to other entities.
This is an example the activity which creates a exposure or risk has been transferred
to other entities. In the same manner even property which creates exposures can be
transferred to others by way of a sale or lease etc.
One another way of transfer of risk is instead of transferring the property or activity,
the risk itself can be transferred to another party. In a Hire Purchase contract the title
to the goods which are brought under the Hire Purchase scheme passes off only
when final installment is being paid up. But the actual physical property is in the
custody and control of the borrower. In view of this situation, wherein the higher
purchase company still owns the asset but is not having custody or control of the
asset this hire purchase company may impose on the borrower the safety of the asset
in question. By doing this as part of the Hire Purchase Agreement the Hire Purchase
company transfers the risk to the borrower.
Unit 7
Risk Control -1
B) Transfer of the financial losses arising from the risk i.e. Risk
Financing.
A
n
other method of Transfer of Risk is Risk financing. In Risk financing

technique, the risk which is originally associated with a person or firm is not
transferred to another person or firm but the latter is asked to finance any
exposure which results on account of relationship between the two parties.
It may be describes as arrangement made to manage the loss exposures
presented by currency fluctuations, interest rates changes and crop price
changes.
To explain this, let us take the case of Franchise relationships like that of
McDonald or Burger King or Pizza Hut etc. When a franchisee
acquires a franchise from McDonald, any risk associated with food
poisoning is still primarily resting with the parent company McDonald.
However if any compensation is to be paid by McDonald, as a result of the
food poisoning, then the actual payment will be done by the franchisee under
the terms of the contract. Under the risk financing there is no transfer of
either the property or activity but then what takes place is only the funding of
any exposure.
Âctivity F:
"Risk transfer may take the form of transfer of the activity that creates the risk."
Explain.
7.10 THE ROLE OF GOVERNMENT IN SAFETY AND LOSS

PREVENTION
Because Safety involves the welfare of workers as also public at large, the
government has also ensured that certain obligations are based on those
involved in activities of manufacturing and production to make sure that
they follow certain minimum safety standards. Various acts have been
enacted to enforce these obligations. Some of the legislation which govern
safety and Loss prevention are:
1.
Factories Act
2.
Explosives Act
3.
Workmen's Compensation Act
4.
Public Liability Act
119
Many Local Governments and State Governments have also introduced safety regulations
specific to certain types of risk like High rise buildings. Similarly specialist organisations
have a role to play in special areas for instance for the oil and gas industry. The Oil Industry
Safety Directorate which works under the Ministry of Petroleum and Natural Gas has
evolved safety standards for the industry.
7.11 SUMMARY_____________________________________________________
In this unit we have introduced several methods for handling both pure and speculative
risks. They include avoidance, loss prevention, loss control, risk finance and risk transfer.
The concept of risk avoidance involves abandoning some activities or declines the risk.
This is the appropriate tool when the chance of loss is high and loss severity is also high.
We have discussed various methods of successful loss prevention and loss reduction. In
loss prevention, activities lower the chance of loss. Loss reduction activities are designed
to reduce the severity of losses that do occur. A example is an automatic fire sprinkler
systems that does not stop fire but prevent from spreading.
In this unit we have also discussed how the risk can be controlled by using methods like
separation combination and transfer. Towards the end we have seen the set up of LOSS
PREVENTION ASSOCITION OF INDIA for promotion of safety and loss control
through education, training and consultancy.
7.12 KEYWORDS
Avoidance
One way to control pure risk is to avoid the property,

person, activity with which the exposure is associated
by
a.
declining to assume the exposure,
b.
abandoning an exposure which is already present.
Loss Control Measures
These are aimed at either lowering the chance or

probability that a particular type of loss will occur or if
it occurs reduce its severity and impact.
Loss Reduction Measures
These aims at reducing or mitigating the impact and

extent of a loss event.
Unit?
Risk Control -1
Risk Transfer
Separation
Combination
It is a process of
segregating a
firm's exposure
to
various
locations
brought
by
concentrating
them at one
location.
It is process by which the number of exposure units

themselves is being increased so that again the Law of
Large Numbers comes into play and then the chances
of loss are reduced.
It is achieved through arranging Financing of the
exposure by another party or transfer to a third party
like Insurer.

i. Distinguish between the concepts of Separation and Combination with suitable
examples.
ii. If you were the owner of a Shopping Mall, which sells floor space as well as leases
out space, how would you handle the exposures you have as an owner by using Risk
transfer and financing methods?
iii. Explain the concept of Avoidance with an example.
iv. Distinguish Loss Prevention from Loss Reduction.
v. Is Loss Prevention possible in the case of State like Orissa i.e. of Storms, Cyclones?
Or would you suggest Loss Reduction measures? Which kind?
7.14 ANNEXURE
Loss Prevention Association of India
Promoting safety and loss prevention
Way back in the 1970s, there was a growing concern in the general insurance industry
about the magnitude of fires, road mishaps, industrial accidents, damage to cargo - resulting
in loss of life and property, most of which was avoidable. It was this concern for preventing
such losses and containing their consequences that prompted the general insurance industry
to promote the Loss Prevention Association of India Ltd. or LPA as it popularly came to
be known.
Loss Prevention Association of India was set up in January 197 8 as a company limited by
guarantee, engaged in promotion of safety and loss control through education, training and
consultancy. When it started, LPAhad a handful of specialists operating from its head
office at Mumbai. Today, it has emerged as a premier safety organisation with multifaceted
expertise, having offices at Delhi, Kolkata, Chennai. Hyderabad and Kochi.
Constitution
The Association is a company limited by guarantee and not by shares. It shall have three
classes of membership, namely, (a) Ordinary Members, (b) Honorary Members, and (c)
Associate Members.
The following five persons shall be eligible and will be recognised as the ordinary members
of the Association, namely (a) The General Insurance Corporation of India (b) The New
India Assurance Co. Ltd. (c) The Oriental Insurance Co. Ltd. (d) The National Insurance
Co. Ltd. (e) The United India Insurance Co. Ltd. and such other bodies corporate and/or
other person as the committee of the Association may at any time and from time to time
decide to admit as an ordinary member of the Association shall be admitted and recognised
as such. The liability of the members is limited.
\
Such other persons who are admitted by the Association as Honorary Members shall be
and be called Honorary Members. Associate Members shall not any voting rights. He
shall, however be entitled to receive such services as may be provided by the Association
and decided by them from time to time.
Objectives of LPA are :

1. To organise and provide a Salvage Corps of trained men to be always ready to
attend at fires with a view to safeguard the interests' Insurance Companies and to
take charge of salvage and to deal with the same and generally to take such steps to
minimise the risk of fire and the consequences thereof.
2.
To organise, prevent and/or minimise all losses to persons or property of any kind or
nature whatsoever arising out of insurable peril of any nature whatsoever on land, sea
or air and to take such steps generally as may be necessary to minimise the incidents
of losses to the General Insurance Industry.
3. To provide organisation and train men with necessary equipment to attend to the
prevention and/or minimisation of losses to persons or property of any kind or nature
whatsoever arising out insurable perils of any nature whatsoever.
Unit 7
4.
Risk Control -1
To adopt, organise, suggest and propagate for the prevention and/or minimisation
of
losses due to fire explosions or by reason of perils to which property in transit
eit
he
r
by sea, land or air is subject or any other loss or damages arising by any reason
or by
accidents caused howsoever.
5.
To educate or train members of the public on the measures to be taken to

prevent
incidents losses and/or damages and to minimise risks to prevent waste of such
property.
6.
To maintain liaison with insurance, companies, fire advisors. State

Government,
Factory Inspectors and advisory services, State Electricity Boards,
Inspectorates of
Explosives, Indian Transport Authorities, Railways, Ship owners, Bureau of
Indian
Standards, Automobile Associations, Road Transporters, Police, Road
Research
Institute, Safety First Association, Port Trusts and Customs, Clearing and
Forwarding
Agencies, Indian Institute of Packaging and the like.
7.
To review existing regulations and practice in the light of experience and to

suggest
improvements and modifications to ensure safety in operation and to prevent
theft,
burglary and pilferage and to ensure and encourage enforcement of regulations
issued
by various organisations.
8.
Protection or research at various levels in order to carry out all or any of the
objects
of the Association.
9.
To investigate into causes of losses and build up and keep statistical records.
10. To publish periodicals, bulletins, magazines, hoardings and literature on loss

prevention
and / or loss minimization with or without collaboration with similar
organizations in
India and other countries.
11. To maintain and provide library, books, journals, audio visual aids, provide
expert
advice on quick and economic rehabilitation after major losses.
12. To undertake risk managements and advice safety audits.
13. T
o
sp
o
ns
or
re
se
ar
ch
in
to
fir
e
ha
za
rd
s
an
d
re
lat
ed
pr
o
bl
e
m
s
an
d
an
y
i
m
pr
o
ve
m
en
ts
in
pa
ck
ag
in
g,
ha
ndling and transportation of different types of cargo.

14. To establish a chain of workshops or approve existing workshops for repairs
to
insured vehicles and organize quick survey facilities.
123
Education, training and consultancy have been the cornerstones of LPA's safety promotion
strategy for the industrial sector.
For additional information please refer the following site:
Site www.lpaindia.org
Reference from book of III.
Unit 8
Insurance : A Risk Financing Tool
entire arrangement of this relationship between the Insurance Company and the
insured is structured in the form of a document which is called as the
Contract of Insurance or more popularly the Policy of Insurance. Insurance
Policies are normally issued and executed for a specified period of time and this
period is called as Period of Insurance.
Generally premiums once paid for a particular period of insurance are not
returned back even if there have been no claims during the period of insurance
(there are few exceptions to this practice). This statement holds good only in
respect of General Insurance with which we are now concerned about. The
other branch of Insurance known as Life insurance which deals with the life of
persons has a different mechanism for payment of premiums and refund of
premiums. We will now start learning about how the transfer of risks takes place
through insurance and how insurance process operates.
Comp
any
has to
pay
out
will
be a
lakh
of
Rupee
s.
Out
of the
total
one
Millio
n
.gT Activity A;
Rupe
Discuss "Insurance is an especially appropriate risk management tool."
es
collec
ted as
premi
um,
the
insura
nce
8.3 MECHANICS OF INSURANCE____________________________________
comp
any
Insurance of property
which
If there are 1000 housing units in a town, assume each of them cost Rs. admin
100,000. If all these houses are to be insured and the rate of premium is 1 %, isters
then each house would pay Rs. 1000 as premium and the total collection of this
premium from all these housing units would be Rs. 1 Million.
insura
nce,
If the probability of any of these houses in this sample catching fire and may
getting totally destroyed is let us say .001 in a period of a year then in any period pay
of insurance (this could be common to all these units), you can expect one house out
to suffer such a loss which means that the amount of money the Insurance Rs.
100,000 and remaining Rs.900,000 is left with it to take care of future losses as
well as provide reasonably for its management expenses as well as a decent
profit.
19Q
But if the probability of 0.001 starts increasing than the surplus left with the Insurance
Company will start diminishing and at the point of time when the probability reached 0.01
the Insurance Company will have nothing left to pay for future losses and will also run
short of money for its management expenses.
This is how General Insurance works. It is all about a certain size of the population to be
insured, certain collections by the way of premium contributions from this population,
certain probabilities, certain loss events actually taking place and certain amounts of
compensation or indemnity paid to the sufferers of the loss.
JSÂctivity B :
Illustrate with example: "From the collection of premia, the insurer pays current misfortunes
and the surplus left is used for future losses."
8.4 INSURANCE AS A RISK TRANSFER TOOL

Insurance Method
In this method there will be a two step process. Coverages available in insurance will be
the focal point of the exercise. All possible exposures have already been identified and
also measured in terms of frequency and severity. Once this is done using the various types
and levels of insurance coverages available the Risk Manager would proceed to classify
the exposures or risks on the following basis:
1.
Essential coverages
2.
Desirable coverages
3.
Available coverages
1.
The Essential Coverages
It includes those that are compulsory because they are required by law. Desirable coverages
are those which provide protection against losses that can seriously impair the operations
of the firm. For instance compulsory automobile Third Party Insurance and Employers
Liability insurance.
Unit 8
Sometimes it may be required under the terms of any contract entered that certain level
and type of insurance coverage will be required to be taken. Construction insurances
taken by Construction contractors fall into this category. Also in this category can be
included losses which have a high severity in their impact. A major fire or explosion in a
Petrochemical / Refinery can be an example of this category.
2.
Desirable Coverages
These are those which provide protection against losses that can seriously impair the
operations of the firm but would not certainly be so severe as to put the firm out of business.
Losses due to accidents whilst the goods either finished or raw materials are in transit,
theft of household goods, larceny of grocery from a shop are examples of this category.
3.
Available Coverages
It includes the types of protection that are not covered in the earlier two categories. The
losses protected under these types of coverages are normally, frequency losses which
would not impact the firms, viability or continuity. The machinery breakdown of motors,
pumps, computers,electrical breakdown of machines etc. could be examples of this type.
Âctivity C :
Write down two examples of Essential, Desirable and Available coverages.
Once the listing as above is done, there can be a review of how the coverages indicated
above could be either purchased or dropped or exposures can be transferred to other
than insurance mechanisms.
There can be losses that can be transferred to somebody other than an insurance company
for a cost less than the insurance premium. Annual Maintenance contracts for equipments
are one such possibility. There can also be losses which are capable of being controlled by
taking suitable loss prevention or control measures and in such cases the prevention cost
could be even cheaper than corresponding insurance premiums.
The Annual Maintenance contracts which were mentioned above are once again an example
of this type. Moreover losses due to small time frequent thefts can also be prevented by
increasing the level of security. Thirdly there are losses which are again frequent in nature
but are of such insignificant quantum that this can rather be retained within the firm. Frequent
breakdowns in machinery of lesser criticality can be rather borne by the firm because the
insurance might be expensive compared to the total would be losses due to this kind of
breakdowns.
By carrying out this type of classification, the Risk Manager will be able to prepare a list
of necessary insurance coverages. After this there has to be a certain amount of priority
listing. Essential contracts will be on the top of this list. Desirable coverages will be either
included or dropped based on the cost considerations. Available contracts however will
be the least on priority. In order to however decide about the cost effectiveness there are
several methods available. We will now examine one of them: it is simpler to use but still
quite effective.
Âctivity D :
State in brief "In certain cases losses can be transferred to somebody else than insurance
in less cost than premium.''
^
8.5 THE LOSS MATRIX

The Loss Matrix is a tool to quantify the effectiveness of various options available for a
Risk Manager. To understand this method, let us look at an illustration as provided below:
Let us take the example of a building owner. In respect of a possible loss due to fire or
earthquake the building owner can either retain the risk or introduce several loss control
measures to bring down the possibility of as a third alternative purchase insurance. The
various cost benefit implications are listed in the sample Loss Matrix.
(Please refer the annexure to this unit)
This method appears too simplistic to study but in fact is the real life situation is not so
simple. There are other quantitative methods available like the Worry method, Capital
Asset Pricing Model, Portfolio Theory Method etc. But since they have a high level of
statistical requirement, we are not highlighting them here. One more method called as a
Unit 8
Critical Probable Method is more or less patterned on the Loss Matrix. The only difference
being that the method uses what is called as Critical Probability Level. This can be defined
as the probability that certain type and level of losses will exceed the premium savings.
Losses above the Critical Probability level will be desirably insured and losses below that
level can be better retained.
Âctivity E:
State in few lines the use of loss matrix regarding the decision about to retain the risk or
purchase a insurance.
8.6 CERTAIN LEGAL ASPECTS OF INSURANCE CONTRACTS

________________________________________________________________
Insurance contracts are subject to certain special principles evolved under common law
and generally followed by courts in India. These principles are known as fundamental or
basic principles of law of insurance. These are as follows:
1.
Utmost Good Faith
2.
Insurable Interest
3.
Indemnity
4.
Proximate cause
Now we will discuss these in detail:

Principle of Utmost Good Faith:
An insurance contract is supposed to be a contract of Utmost Good Faith. The principle
emanates out of the fact that a risk which is being offered to an insurer for coverage, the
proposer of the risk is in substantially better position to know about the risk than the
insurer himself. Since there is a knowledge gap, it becomes the duty of the insured i.e., the
person or the firm proposing to avail insurance from an insurer, to render full information to
the insurer.
134
Insurers also operate on commercial principles, which mean that they also have
to make business profits to grow and survive. Therefore they have every right to
decide whether they should be offering coverage for a particular risk or not.
They also have the right to impose certain conditions either to improve the risk or
to restrict their liability if the risk is not a very good one.
Ultimately they also have to decide about what price the risk deserves for
coverage. In order to enable an insurer to make this kind of decisions, full
disclosure of information (material facts) about the risk to be insured is necessary
and only the insured can provide it. Any suppression of information or misleading
information, which could have been crucial for insurers' decision, will result in
avoidance of any obligation by the insurer under the contract.
Examples of material facts :

Fire Insurance : Construction of the building, occupancy i.e.
residence,shop,office etc,decription of goods ,whether non hazardous,
hazardous, nature of process carried out etc.
Marine Insurance : Mode of transport (road / rail / air) method of packing (in
plastic container, double gunny bags) type of goods (solid, liquid or gaseous), name
of destination.
Motor Insurance: Carrying capacity, type of vehicle, year of
manufacture, etc. Mediclaim Insurance: Completed age, pre existing
diseases, etc.
Âctivity F:
"Insurance is not possible unless material facts are revealed "Explain with
examples.
2. Principle of Insurable Interest:

Another major fundamental principle in insurance contracts is the principle of
Insurable Interest. Insurance not being a gamble, there should be a rationale for
any one to have insurance for any property or person. This rationale is that if
anything happens to the person or property insured, then the person proposing
for insurance, namely, the insured
Unit 8
should suffer financially. Otherwise this person is not entitled to any compensation and
therefore is not entitled to any insurance coverage also.
The insurable interest, may be define as, "The financial interest between the insured and
the subject matter of insurance gives legal right to insure"
The essential features of the insurable interest are
1.
There must be some right, property, or liability capable of being insured.
2.
Such property, right etc. must be subject matter of insurance.
3.
The relation must be of a nature that insured benefits from its safety and loses due to
its loss, damage of subject matter.
4.
This relationship must be recognized by law.
The insurable interest arises due to

1.
By common law: For example ownership - An owner of a building would suffer

financial loss if it is destroyed or damage by fire.
2.
By contract: By contract the person is liable for safety of property. In hire purchase
agreement the hirer is responsible for damage or loss of property hired.
3.
By status:: A bailee is responsible for damage to goods in his possession due to his
negligence. Other e.g. Laundryman, warehouse keeper, motor vehicle repairer.
Three main categories of application of insurable interest are

1. Life: Every person has insurable interest in his own life, in the life of person's husband
or wife, By financial interest in the other person being a business partner.
2
Property: It arises due to ownership of the property, Executors and trustees responsible
for property in their charge, etc.
3.
Liability: It exists due to liability which may be incurred by way of damages and
other costs. For example public liability, third party liability, etc.
Âctivity G:
Write down when the insurable interest arises with three examples in each case.
3. Principle of Indemnity
Indemnity means compensation for loss or injury sustained. The principle of indemnity
arises under common law which requires that an insurance contract should be a contract
of indemnity and nothing more than that. Insured is prevented from making any profit from,
out of loss or damage. He in other words placed in the same financial position before the
loss occurred.
The principle of indemnity follows the principle of insurable interest i.e.
i)
An insured can recover a loss under the policy only if he has insurable interest.
ii)
Insured can recover a loss only to the extent of his insurable interest.
The following example will illustrate the points:

'A' has a fire policy for Rs. 150,0007- where as the value of the property is
Rs. 100,0007-. He sells the property on 11.3.2006 and a fire occurs on 14.3.2006 then
no claim will be payable as he has no insurable interest on the date of fire.
Suppose "A" has not sold the property and fire occurs on 14.3.2006 and property totally
burnt then he will receive only 100,0007- and not Rs. 1500007- as his financial loss is only
Rs. 100,0007-.
If the indemnity is not applied then the transaction would be a mere gambling.
According to this principle no one can gain financially out of insurance unduly. As we have
said earlier insurance contracts are not meant for giving undue financial benefits. If a person
or a firm has financial interests then if something happens to the property insured then, the
person or firm insuring it (the insured) should be neither better off nor worse off than they
were before the accident took place.
Unit 8
To illustrate, if a firm has insured its old machinery for certain values, after an accident to
such old machinery, the owner of the firm should not be gaining by getting new machinery
or its cash value. Therefore on the value of the machinery, reasonable amount for depreciation
will be applied if the machinery has to be replaced.
Methods of indemnification:
Cash payment: Majority of cases the claim will be settled by giving the insured a cheque
for the amount payable under the policy.
Repair: This method is of extensive use as method of providing indemnity. Motor insurance
is the best example of this as garages are authorized to repair the damage vehicle.
Replacement: It the damaged property is beyond repair then indemnity on the basis of
replacement is offered.
Reinstatement: It refers to property insurance where an insurer undertakes to restore
or rebuild a building or piece of machinery damaged by fire or by breakdown under
engineering policy.
Measurement of Indemnity : In property, liability and other non-life insurance, the
exact amount of compensation is not known in advance. Unlike benefit types of policies
and personal accidents policies. The method by which indemnity is measured is to be
measured depends upon the nature of insurance involved.
Following this Principle of Indemnity, there are two corollaries called as Principle of
Subrogation and Principle of Contribution.
Subrogation: It ensures that if an insurer pays a large amount to the insured on account
of any loss and if this loss has been caused by a Third Party, insurer can assume the rights
and remedies of the insured after paying the loss and work on claiming it from those who
caused this loss i.e. the Third Party.
Contribution : The Principle of Contribution also makes sure that the insured sets no
more money than he lost. If there are more than one insurer insuring either the whole or
part of the affected property then the total amount recoverable from all these insurers in
the event of a loss should not be more than the actual loss. This means that the total loss
amount will be apportioned among various insurers.
Also insurers not only expect proper disclosure at the time of going on cover. They also
expect the insured to have certain responsibilities i.e. to do certain actions or not to do
certain actions during the currency of the insurance policy. E.g., the insurer may insert a
condition in the insurance policy that during the entire period of insurance cover the insured
will maintain proper Fire protection equipment. These kind of conditions are called as
Warranties and if such Warranties are not observed by the insured, then the insurers have
the right to avoid payment of losses particularly if such breach of Warranty contributed
either to the occurrence of the loss itself or increases the extent of the loss.
Âctivity H:
Write down methods of indemnification with two examples each.
4. Principle of Proximate Cause

If the loss is brought about by one event, no question of liability arises but if the toss is due
to more than two or more causes, acting simultaneously or one after other, then it becomes
necessary to find out the most important, effective and powerful cause which brought the
loss. This cause is defined as "proximate cause" all other causes are considered as remote
The claim is payable if the loss is resultant of peril insured against. Hence the practical
effect is to keep the scope of insurance within the limits intended by the parties, i.e. insured
and insurer.
It defines not only the scope of coverage under the contract but also to protect relative
rights of the parties to the contract thus maintaining a balance.
Many losses will have a unique set of circumstances and establishment of proximate cause
will arise from the application of common sense.
Example:
1.
A motor vehicle dashed by other vehicle and met with an accident, as the single cause
which is within the scope of the policy and the claim is payable.
2.
Insured met with an accident and admitted in the hospital for treatment. During the
treatment period he contracted an infection and caused his death. The proximate
cause of death was disease and not the original accident hence claim is not payable
under personal accident policy.
Unit 8
Âctivity I;
Comment on "Proximate cause" maintain the true intention of the parties to the contract
regarding the rights between the insured and insurer.
8.7 SUMMARY______________________________________________________
In this unit we have introduced Insurance as a appropriate Risk Management Tool when
the chance of loss is low and the severity of loss is high. It allows the purchaser to substitute
a small certain premium for a large uncertain loss.
We have also seen the mechanism of insurance and essential terminology used in Insurance.
If the cost of insurance premium is more than to retain the risk or the cost of preventive
measures, then other form to protect the property is the best solution.
We have also discussed the risk can be classify into three types of coverages and can
decide whether the coverage can be transferred or retained. Insurance is a legal contract
and based on certain principles. We have discussed the utmost good faith in which disclosure
of material fact is essential. Unless there is insurable interest, one cannot insure his property
or liability, With the principle of indemnity, insured places in the same financial position
before the loss.
After the loss is paid, the insurer subrogates the rights of the insured and exercises their
recovery rights. If the property is insured with more than one insurer, claim is paid in
contribution. Proximate cause defines scope of the policy and protect relative rights of the
parties to the contract.
8.8 KEY WORDS
Insurance
It can be defined as a process through which the losses of

few are compensated from the contributions of many to a
fund, which is administered by an insurer.
Premiums
The contributions to the pool, which are considerations for

the Insurance contract.
Insured
The contributors of Premium, who have an insurable interest in

the subject matter of insurance.
Claim
The demand the contributors make on the insurance company in

the event of a loss suffered by them.
Contract of Insurance
or Policy of Insurance
The document evidencing arrangement of this relationship

between the Insurance Company and the insured.
Period of Insurance
It is the specified period of time for which an Insurance

document is structured.
Essential covers
The essential contracts includes those that are compulsory

because they are required by law.
Desirable coverages
These are those which provide protection against losses that can
seriously impair the operations of the firm.
Available coverages
It would include the types of protection that are not covered in

the earlier two categories.
Principle of Utmost
Good Faith
Insurable Interest
Principle of Indemnity
140
Means it requires the Insured to render full information to the

insurer.
This rationale is that if anything happens to the person or
property insured, then the person proposing for insurance,
namely, the insured should suffer financially.
If a person or a firm has financial interests then if something
happens to the property insured then, the person or firm
insuring it (the insured) should be neither better off nor worse off
than they were before the accident took place.
Unit 8
8.10ANNEXURE
LOSS MATRIX
Payout
(Rs.)
No Fire
Payout
(Rs.)
500000
No Losses
Nil
10000
510000
Total Payout
Nil
Retain the risk and Losses which could
300000
No Losses
implement Loss
Prevention
Measures
Non-insurable accidental
losses
2000
Cost of Safety measures
12000
Decision
Fire Occurs
Retain the risk
Losses which could

have been insured &
and claimed
Non-insurable accidental
losses
Total Payout
have been insured
Cost of Safety 12000

measures
Purchase
Total Payout
314000
Total Payout
12000
Insurance Premium
10000
Insurance
10000
Insurance
Losses recovered
(500000)
Non-insurable
losses
5000
Total Payout
15000
Premium
Noninsurable
losses
Total Payout
5000
15000
146
9.1 INTRODUCTION
As we have seen in the earlier units insurance happens to be the most
convenient Risk Transfer Mechanism. Due to industrialization, Increasingly
complex conditions of modern life, growing consciousness about the legal rights of
recovery, accidents resulting into injury or death, property damage have become
almost inevitable.
All these developments have influenced the growth of insurance industry in a
variety of forms to provide the necessary protection. Because there is a great
variety in the interest or subject matter to be insured, there is also great variety in
the types of insurance covers. But insurance can be broadly classified to fall
into three major categories : Property, Casualty, and Liability. We shall now
see each of these classifications in greater detail.
9.2 PROPERTY INSURANCE_____________________________________

^_
All types of tangible property are the subject matter of the property class of
insurance. This could be movable assets like goods which are in transit or
immovable assets like buildings, machinery etc. This could be small units like
residential houses to huge installations like a big manufacturing factory. Again
this could be on land or offshore. s
By and large, the property class of insurance is offering protection to a great
variety of subject matter and therefore it forms the largest portfolio of any
insurance company, in general. Normally property clause offers protection
against perils like Fire, Lightning, Explosion, and Damage due to impact by
Rail or Road vehicles, Damage due to impact by aerial devices etc.
While these kind of perils form the basic coverage, there can be additional perils
like perils of weather - flood, storm, cyclone etc., as also catastrophic perils like
earthquake, landslide etc. This coverage is basically available for property
onshore and static. For offshore property in addition to the perils mentioned,
there can be additional perils covered like impact by vessels. There are covers
which specify the kinds of perils covered as well as there are covers which are
broader in coverage and which are generally called as Comprehensive, or All
Risks insurances.
For property on the move, the insurances available are either covering carriers
like ocean going vessels or passenger ferries etc. or covers for goods in
transit either across International borders or on high seas or in air. Even goods
which are on movement on land can be covered against Inland Transit policies.
These properties on the move can be again covered on a Named Peril basis or on
a Comprehensive basis, (in all our discussions the term "peril" means the cause
which brings about the loss event).
Unlike property insurances the life of either human beings or other human beings cannot
be quantified. Once exception to this assumption is that where a living being is traded, like
horses or cattle then an economic value can be attached to this kind of being. Hence the
Principle of Indemnity undergoes a modification in Casualty Insurances.
In the case of Personal Accident and Sickness insurances, they operate more on a agreed
value or reimbursement basis. When we say Agreed value we mean that the amount for
which insurance is effected (Sum Insured) is agreed at a particular level between the
insurer and the insured. For instance a typical Personal Accident cover provides
compensation in the case of death or various types of physical disability. If an accident
results in the death of the insured person, the policy would pay 100% of the Sum Insured.
(There of course will be methods of relating the Sum Insured to the economic status of the
person insured). In the case of various levels of physical disability resulting out of the
accident, depending upon the percentage of loss of earning capacity the compensation is
paid as same percentage of the Sum Insured, As for sickness benefits such policies would
be more on a reimbursement basis subject to an overall limit. However in the case of
beings where an economic value can be attached the Sum Insured is fixed in relation to
such value, e.g. Race horses which are of special breed and lineage do have a tradable
value on them. Therefore any one acquiring such horses from a stud farm will necessarily
like to insure them for such values. In such transactions the valuation can always be verified
by the way of expert opinion.
Exotic insurance schemes like those of Sericulture, Prawn Farming, Horticulture all operate
on similar principles of previously agreed basis for valuation. Casualty insurances provide
indemnity for both occurrences caused by perils external to the subject matter of insurance
as well as to perils inside the subject matter. A road accident is an example for the former
and a heart attack is covered under medical insurance for the latter.
In all such cases in order to ensure that the principle of Utmost Good Faith is complied
with, a declaration from the insured will be taken along with the proposal for insurance.
This declaration aims at making the insured disclose all material information which is relevant
for insurer's decision to accept or not to accept the proposal or impose certain conditions.
Sometimes even an inspection or a medical examination might be necessary before accepting
such proposals. All General Insurance policies are issued for a period of one year (other
than Construction insurances or long term specially agreed insurances) and casualty class
is no exception.
Unit 9
Types of Insurance Covers
Âctivity B :
Explain the statement "The Principle of Indemnity undergoes a modification in Casualty
Insurances."
9.4 LIABILITY INSURANCE

We have seen earlier that in a civil society there are lot of obligations and responsibilities
on the part of citizens to fellow citizens as well as to the public at large or society at large.
Also contractual relationship between various members or units of the society also creates
legal obligations. Hence a separate class of insurances called as Liability Insurances provides
indemnity in respect of legal liabilities. Many of such legal liabilities insurances exist separately
and many times they also are included in certain other property or casualty policies. Examples
of legal liability policies are:
Comprehensive General Liability, Employer's Liability, Lift Owners Liability, Aviation
Liability, Ship Owners Liability, etc. General Liability policies take care of the compensations
or awards imposed by the courts as well as associated defense costs and these policies
are available to any type of firm or enterprise. Employer's liability policies cater to the
responsibility of employers for ensuring the welfare of their employees. Liability policies of
specific industries like aviation and that of ship owners address the legal obligation on the
part of these owners or users to compensate for both property and personal injury of
passengers and Third parties.
Many of these liability policies can be suitably amended to provide for liabilities in respect
of environmental preservation. Pollution Liability extension is one such case. As more and
more types of legal liabilities evolve, insurers rise up to address these kinds of concerns.
Liability insurances have a different yardstick altogether for methods of fixing the policy
values as well as methods of Indemnity. Since the exposure to these liability producing
events are again a function of the probability of such events, however the amount quantified
for discharging the legal liability depends on so many factors. These factors include the
general system of legislation in the country.
Legislation and regulations which are specific to the kind of liability, the standard of living,
general economic conditions, the approach of judiciary, socio-economic influences etc.
Legal Liability arising out of Automobile accidents is governed by the Motor Vehicles Act
and related regulations. Under these regulations limits are prescribed for liabilities towards
property damage and the formula is prescribed for calculating compensation in the case of
personal injury. Therefore insurance policies covering Legal Liability for automobiles can
very specifically cover the limits of liability in the policy. Whereas in the case of general
liabilities one has to go by many of the factors mentioned above taking into account also
the previous case histories as decided by the courts.
For instance a factory owner who is required by law to avail of a Workmen's Compensation
Policy can find it easy to buy coverage for compensations exactly as prescribed in the
Workmen Compensations Act. Unlike this, the same factory owner who has to buy
protection for pollution liability has only to depend upon his own risk perception as well as
previous cases decided by the courts of law. Since limits of liability are not clearly determined
in many of liability policies, there is always a hidden exposure in respect of these liabilities.
The term Legal Liability implies that the extent of liability either is determinable like in the
case of employer's liability or has to be decided by courts in specific cases. So in the4atter
case it would appear that the parties to the case have to wait for an award from the
concerned court. However since there are long delays in the judicial process, Liability
policies provide for an out of court or agreed settlement between the parties. The only
requirement for such settlements to be honored by the insurance company is that the
insurer should be fully involved in the process of settlement. Normally these policies also
provide for the associated expenses which are incurred in the carrying out of the
proceedings. For instance the fees of the advocates, the expenses incurred in traveling to
appear before courts all are recoverable from such liability insurances, the limit being the
policy limit.
Though we have seen the categorization of insurance covers available to the above three,
there are still many more types of insurance which do not strictly fall into any one of these
categories.
One classic example is the Financial Risk covers. These types of covers straddle over
many classes of insurance. Part of them could be Property, like in the case of Bankers
Indemnity Policies - Theft or Burglary at Bank premises. There are legal liability sections
catering to the Bank's responsibility towards its customers as well as other partners in
banking. The latest in this kind of multi class insurances are those relating to Information
Technology Industry.
Unit 9
Âctivity C:
"Since limits of liability are not clearly determined in many liability policies, there is always
a hidden exposure in respect of these liabilities." Explain with examples.
9.5 THE REASONS FOR BUYING INSURANCE

The reasons for buying Insurance can be dealt with under the headings of risk transfer and
other reasons.
Risk Transfer
Insurance provides a means for handling risks with a low probability of suffering a large
loss which an organization cannot afford to retain itself. The transfer of risk can take two
forms:
1.
The transfer of the activity that creates a risk
2.
The transfer of the financial losses arising from the occurrence of the risk.
The commonest example of (a) is the subcontracting of particularly hazardous activities

such as underwater pipelines in civil construction, installation of firefighting equipments in a
chemical factory. Insurance is the most important form of (b) It is better to buy insurance
for risks with low frequency and high loss severity.
The other reason besides risk transfer to buy insurance is the value of the various services
which an insurer may provide as a part of insurance package. Those services are as
follows:
Risk reduction advisory and inspection services
Risk financing and other advices
Claims handling services
Risk reduction services include inspection of premises, plant, system of work and suggest
risk reduction measures comply with the factory act and other safety regulations. Similarly
fire and theft insurers are advice on risk reduction measures during the planning stage of
the building plant. Fidelity and credit insurer advice on audit and credit control systems.
Insurer and brokers are usually willing to advice on exemption, indemnity, employee benefits,
and insurance clauses in the contracts and so on.
When a loss occurs, insurers provide a variety of services and advices according to the
class of insurance concerned. They offer expert advice on salvaging of damaged property,
names of specialist repairs.
Âctivity D :
List out the services provided by the insurer as part of the insurance package.
9.6 THE BENEFITS OF INSURANCE

In its earliest form insurance started more or less on the patterns of a gamble.
Itstarted with the maritime trade, wherein the owners of ships and cargo which were
meant for far away destinations used to pay some amounts of money into a pool. If
the voyage was successfully completed, then the amounts were returned and if not,
the losses were paid from the pool. What we will have to remember is that as
insurance developed it was no longer a gamble. We have seen earlier that gambling
involves Speculative Risk. One may gain or one may lose in a gamble.
But Insurance involves Pure Risk. This is one of the fundamental principles of
insurance which is stated in what is called as 'Principle of Indemnity'. Under this
principle any one who is insured if he or she suffers a loss, they should be placed in
the same position financially as they were before the loss. This means there cannot be
any financial gain out of a policy of insurance. Now let us see as to why people or
firms should insure. The reasons are many:
1. Insurance provides Indemnity: If an individual or a firm suffers a loss which
is payable under an insurance policy then they get compensated sufficiently so
as to regain their financial position as it was before the loss occurred. This way
insurance has been a great provider of relief.
Just look at this. A massive earthquake which shook Gujarat on 26th of
January 2001 claimed a death toll of almost 20,000 lives. Economic loss to the
country is
Unit 9
estimated at a whopping level of 25,000 Crs. of rupees. Of this, the Insured losses
are in the range of Rs. 500 Crs. By insured losses we mean that the amounts payable
under various types of insurance policies is just about Rs. 500 Crs. Compare this
with the total general insurance premium in India which will amount to roughly
Rs. 12,000 Crs. You will be able to appreciate that one loss and just one loss has
reduced the insurers by almost Rs. 500 Crs.
This is just an illustration as to how insurance is beneficial. Similarly the recent floods
in Europe have caused an Economic loss of almost Rs. 20,000 Crs. Compared to a
country like India the penetration of insurance is very high in countries of Europe and
therefore one can conclude that substantial part of this estimated economic loss would
have been picked up by insurers.
When we talk of indemnity, it is not just an amount of compensation. In the case of
lives lost, particularly, of heads of families or the earning members, the insurance
industry restores economic well being to the family by providing Indemnity. Similarly
in the case of firms manufacturing or providing services the business are able to
regain their viability and start working again.
2. Reduction of Uncertainty: In the opening chapters of the book we have studied
the economic cost of risk. Risk causes worry and if the uncertainty is not either
reduced or removed totally then an individual or a firm shy away from the risk bearing
activity. By transferring the risk for a small consideration, the individual or firm are
free to undertake such activities. We have earlier seen, the risks which beset a
construction company, which is about to build a huge flyover.
Even though we have seen possibilities of transferring the risk of supply of materials,
the labour etc., to subcontracting companies, either the original construction companies
or subcontractors themselves may not sometimes be able to achieve such a transfer.
If the supply of materials contract is worth, let us say Rs. 500 Crs. and if substantial
part of this supply of materials is accumulated in one location, a major natural
catastrophic event like the earthquake or flood can damage the materials in a great
way.
So even if the construction company has managed to transfer the risk to the material
supply contractor, the extent of loss is so huge that the contractor may become
financially bankrupt with this loss. If, either the original construction company or the
subcontractor have availed insurance for the storage of the materials, then the risk
associated with a catastrophe like earthquake or flood would have been insured
under the policy of insurance. The insurer then, steps in to compensate the construction
company or the subcontractor which will help him to arrange for re-supply of the
Risk Management in
General Insurance
T
materials . Hence the uncertainty about the survival of the
Construction Company or subcontractor after such a huge loss is
totally transferred to the insurer for an appropriate premium.
Insurance meets the financial consequences of certain risks provides a
form of peace of mid. Insurance of asset is important as far as the
businessman is concern but also to industry and commerce. If the
people do not invest in the business then it would be fewer jobs, less
goods, the need for higher imports and greater reduction in the
wealth. Buying insurance allows the entrepreneur to transfer the risks
of business to an insurer.
Insurance also acts to stimulate the activities of the business which
already in existence. Release of funds for investment which would
otherwise to be held in reserve to meet future losses such as fires,
thefts, serious injuries and so on. Hence firms are free to continue its
business and with this peace of mine it can develop its business
activities.
Âctivity E :
It is really possible to just invest money in the premium and transfer the risk
of loss to
somebody else?
s
3. Investments: Another major contribution from Insurance Companies

to the national wealth is in the form of investments. As we have seen
the mechanics of insurance is such that premiums are collected and
claims are paid out of such collections.
However, though premiums are collected throughout a financial year,
claims need not necessarily happen on everyday of the financial year.
Also the extent of claims need not be so bad that they will wipe out
whatever collections are available with the insurance company.
On account of both the reasons, the insurers always have a surplus
in financial terms which can be gainfully utilized by them.
Normally insurers do it in the form of investments. Investments can be

in the form of tangible assets like Real Estate or in the form of
securities like stocks, shares, bonds etc. By making these investments
insurers add to the Gross Domestic Product of the country. Insurers
are also sometimes required by law to invest a sizeable portion of
their investment funds into socially relevant areas. Till recently, in
India, Insurance
Unit 9
companies were required to invest almost 70% of their inventible surplus, in areas
like housing finance, Infrastructure projects, social welfare schemes etc. Through this
kind of a contribution Insurers in India have helped not only the government but also
the private sector by providing funds for their projects as well as working capital etc.
jgT Activity F;
Give reasons why "The insurers always have a surplus in financial terms which can be
gainfully utilized by them in investment."
4. Stability: Insurers also help in providing stability of pricing in products and services.
If firms providing products and services are uninsured and if they suffer losses to their
premises or inventory due to either manmade perils or perils of nature, they will
naturally try to recover the lost values in their pricing.
Take for example the crude oil imports, this is already a very volatile commodity
where pricing is affected by political, regional and similar such reasons. Added to
this, if losses to the oil wells or offshore platforms which supply crude, take place,
then these firms will have naturally to offset such losses by increasing the price of
crude. If there is no insurance against these kinds of losses then the crude price will
suffer high volatility. This will in turn have a cascading effect on many other segments
of the economy which depend upon petroleum products.
Therefore, when insurers provide indemnity for such losses at places of production,
then the oil firms can balance their prices appropriately. Moreover, it may not be
always possible for all firms to bring about price increases because of competition.
Small and medium business may lose out if they increase prices due to uninsured
losses and they may eventually even go out of business unable to compete with the
other suppliers. It will be interesting to note that insurance also comes handy in services
which are critical to human welfare. In countries like Untied States of America which
are highly litigious, the legal liabilities and costs out of medical negligence are so high
that medical practitioner simply cannot render services if they do not have adequate
insurance against negligence.
Âctivity G:
State your views for the following statement:
"Insurance provides stability to the business which results in stable prices and services."
5. Loss Control: Insurers do have interest in reducing the frequency and severity of
losses, not only to increase their profit but also to contribute to general reduction in
the economic waste which follows from losses. As such insurers plays a major role in
loss control over many years.
Now a days insurance industry pools its resources and funds in continuing research
work into prevention and control of many forms of loss, develops expertise in the
technology of different forms of loss control.
s
Formation of Loss Prevention Association of India plays an important role in loss

prevention, loss reduction and loss control. The surveyors and specialists advise on
pre loss and post loss control.
Âctivity H:
How does loss control help to increase profit?
6. Social Benefits : Funds are available to stimulate the business activities, the social
benefit is that the j obs may not be lost ,the sources of income are maintained and they
can continue to contribute to the national economy. There is a depression to the
'society if the employees cease to work as people have less money to spend and then
the consequences are different. The same result is there by closure of the business. If
the losses are aggregated throughout the country the effect is considerable. Insurance
alone keeps people in jobs but play significant role in ensuring that there are not
unnecessary hardships.
Unit 9
By providing different types of social insurance like solatium funds, Third party
insurance, Universal Health insurance, charging lower premium to farmers supports
the national economy
Âctivity I:
Describe the social benefits of the insurance sector.
7.
Invisible earnings:
Insurance allow people and organization to spread risk among them. In the same
way countries spread risks. Large insurances are transacted world wide i.e. property
and liability insurance. Due to reinsurance arrangement large amount of premium
flow into India every year. These are described as invisible earnings.
As a national trading we have to import goods and export goods which other people
buy. Where goods are tangible, a visible export trade exits but in case of insurance,
goods are invisible but it also brings money into India, and imports are sending money
out.
In addition to insurance, tourism is one form of invisible earnings.
9.7 SUMMARY
___________________________________________________________________
In this unit we have explained the various types of insurance available to cover property,
casualty or liability. Major portfolio is of property insurance. To cover special assets different
policies are designed. Packages policies are introduced to provide different covers in a
single policy and it becomes a very popular form of insurance.
We have discuss the various reasons to buy insurance. The primary function of insurance
is to act as a risk transfer mechanism when the chance of loss is low but the severity is high.
We have also discussed the various benefits of the insurance. Peace of mind, loss control
and social benefits help to stability and increase the national economy as a whole.
9.8 KEY WORDS

Property Insurance
: Insurance of all types of tangible property.
Casualty Insurance
: It deals with losses relating to people as well as interest like

live stock.
Liability Insurance
: It provides indemnity in respect of various legal liabilities.
9.9 SELF-ASSESSMENT QUESTIONS__________________________________

i.
What kind of subject matter is covered under the three categories of insurance classes
you have studied?
ii.
If you are asked to address a Chamber of Commerce meeting, on the Benefits of

Insurance, what would you tell the audience?
iii. Are casualty covers subject to the principle of Indemnity?

iv. Write a note on insurance benefits.
10.1 INTRODUCTION
Retention is an equally important tool of Risk Management. As important as the other
tools available. Ultimately as Risk Management is all about balancing of risk and resources.
Retention sometimes could be the most cost effective way of managing risk.
As seen in the last unit, risk avoidance and risk reduction decisions are taken without
taking into account their financial costs and benefits but before taking any decision regarding
retention, financial aspect and benefits derived from them is taken into account.
Business firms retain the risk when:
Loss costs are small and will be funded by current cash flow.
Loss exposures are retained and funded with a cash flow.
Loss exposures re retained and recognized in an unfunded reserve account
A self insurance plan is operates.

>s
We will see in this unit the methods of financing risks internally:
1.
Charging losses to operating costs
2.
Setting up contingency (self Insurance) funds
3.
Use of captive insurance companies.
In general, when the severity of losses is relatively low and the frequency of loss is also
low, retention is desirable.
10.2 RETENTION AS CONSCIOUS DECISION ___________________________
Retention as a deliberate measure of Risk Management happens in the following ways.
Firstly when the exposure or risk are of either very low probability or of very low severity
the effect of such losses on either the property or business continuity are so low that it
could be easier for the firm to retain such losses on its books.
Minor breakdowns in machinery which do not disrupt the production process are example
of such losses. Business often assumes the risk of losing items of relatively small value such
as hand tools for a manufacture or utensils in case of restaurant.
Unit 10
Retention
The factory may have spare machinery so that if any operating machinery breaks down it
can easily be removed and substituted by the spare. But such breakdown exposures can
easily be carried by the firm itself as even if a transfer is available in the firm of insurance
the procedure for transfer as well as making claims might be cumbersome. Thereby making
it cost ineffective.
Moreover there might be also effective loss minimisation or loss control measures which
also can bring about the ultimate exposure to low frequencies or low severity so that the
firm can retain such losses. To illustrate, in Marine Transit policies for finished goods there
may always be small shortages when the goods are delivered to final destination. By
improving the methods of packing as well as using reputed cargo carriers; the occurrence
of such loss can be minimized. Also the procedure for preferring claims for such small
shortages is so tedious that it would make more sense to retain such losses on the books.
Secondly, Retention can be used where the cost of transfer to insurance and similar tools
is more expensive than the effect of retention itself. In the previous chapter we saw the
Loss Matrix method through which an evaluation between the financial impact if certain
types of exposures are retained and the cost of transfer was done.
Sometimes business has to retain the risk as there are gaps in their insurance program or
somebody neglect to purchase needed coverage.
Âctivity A:
"Charging of losses from current cost is one of the effective risk management tools." Do
you agree?
10.3 RETENTION AS A COMPULSION

There were also circumstances under which retention gets compulsorily imposed in the
Risk Management Process. The classic example is that of War Risks. War Risk of such a
catastrophic nature that the economic impact of war could be too huge for any firm or an
insurance company to carry. Hence in a war or a war like situation, war cover for properties
on land is seldom available. However since it can lead to an economic collapse if small or
medium firms are allowed to canyon without any protection, in most countries the
government becomes the Insurer of last resort.
164
Sometimes covers like war are not simply available through any transfer
mechanism or sometimes they are too expensive for any one to purchase.
Post September 11th, the cover for Terrorism was hardly available. Wherever
it was made available on limited extent, the insurers had to collect huge
premiums from the insured.
Another reason for compulsory retention is when it is attempted to be
transferred. Sometimes when risk transfer takes place through insurance,
depending upon the hazard profile of the risk as well as its loss history, the
insurers may impose certain deductibles otherwise called as excess or franchise.
What these mean is that for each and every loss for which a claim is made on the
insurer, the insurer expects the insured or the claimant to retain a certain extent of
loss and pays only the balance.
To give you an example, if an insurance policy against automobile accidents
carries an excess of Rs.500 then for every claim for a loss made under this
policy the owner of the automobile will have to bear the first Rs. 500. Such
deductibles are more often imposed to make sure that the insured becomes
prudent and does not pass on his negligence to the insurer. By making the
insured bear a proportion of the loss the insurer ensures that the insured
maintains the risk properly and thinks twice before making a claim.
Such deductibles as mentioned in the previous paragraph also remove the
hassle and administration involved in making claims for small losses. Compulsory
retention also takes place through insurers in placing a loss limit for a particular
type of insurance. For instance in the case of pollution liability, which pays for the
legal liability arising out of polluting or contaminating the environment, the insurer
cannot be expected to have a limitless liability. Therefore, the insurer places a
ceiling on the amount of liability for which insurers will be responsible. If at all
an award is passed by a court in respect of an insured for a certain amount, then
the insurers liability will be only restricted to the limit mentioned in the insurance
contract. Anything above that will have to be borne by the insured.
Quite often, retention also becomes a compulsion because the transfer for such
risks is simply not available. A simple case of such imposed retention is in Marine
Transit, wherein if the vessel carrying the cargo is not fulfilling certain standards like
Country of Registration, the Dead weight Tonnage (DWT) and similar parameters,
then insurers will not be providing cover for such cargo. Retentions also are
useful in making the insured maintain the risk with better standards.
Retention through deductibles also is at times useful in effecting savings in
insurance premiums. Since insurers do not have to respond to small and
frequent losses which are falling below the level of deductibles, they are freed
of administrative costs. Hence they offer significant reduction in premiums. The
rule is, the higher the deductible the lower will
Unit 10
Retention
be the premium. Deductibles, it is to be learnt, can be pure monetary deductibles or at

times can be expressed in the form of time units. Monetary deductibles are normally used
for Property Damage Indemnities. Time deductibles are used in the case of Business
Interruption covers, whereby the deductible turns out to be the waiting period before
which the interruption can be counted for indemnity. So if there is a time deductible of 30
days for every loss in a Business Interruption cover, then the insurer will calculate the
period to be compensated by deducting 30 days from the total interruption period.
Âctivity B ;
List out the usefulness of the deductibles as a form of retention.
While selecting the method of retention, it is necessary that the cost of losses will be
spread evenly over the time in order to avoid sudden financial crises due to effect of a
large loss occurring.
10.4 THE CHARGING OF LOSSES AGAINST OPERATING COSTS_________
An organization will need to absorb the additional expenses of loss against the operating
budget within a short duration. Its ability to do so depends upon the availability of surplus
of receipts over other payments through out the year or more than sufficient liquid funds
available either in the form of bank balance or overdraft facility, investment funds. Therefore
the size of the loss that could be absorbed along with the current expenses will depends
upon the size of surplus plus liquid reserves and/ or short coming borrowing.
Availability of money when it is needed but avoids the idle cash bank balance makes no
contribution in the earning is the success of financial arrangement. For small, fairly
predictable, regular losses the funds are available but in case of large fluctuations in normal
cash flow, the management is reluctant to set aside additional liquid funds for replacement
of damaged property .Actually all losses are not paid in full as soon as they occur but can
be spread over a considerable period of time.
For example many large firms retain some or all of their health insurance or workers'
compensation costs because these losses are predictable accurately. Some firms may give
a accounting reorganization to the expenses of retained risks by
maint
ainin
g an
unfun
ded loss reserve account to provide a most realistic firms' financial

position.
^ Ac ti vit y C:
The ability to absorb the losses against operating costs depends upon
financial position of the organization. Give examples to explain your
answer.
10.5 CONTINGENCY FUNDS (SELF INSURANCE)

When large and unpredictable losses are decided to retain internally
against operating costs, the solution is to set up an internal contingency
fund so that costs of losses can be spread over considerable period. Such a
fund can be financed by transfer of capital or by paying periodically like a
premium for insurance but like premium; contribution towards contingency
fund is not taxable.
As the fund needs to be in the form of readily realizable asset, it
cannot be used for investment as the organization loses it's interest ,secondly
it cannot be used for the expansion of the business. Hence amount to be
transferred to the fund depends upon the exiting liquid reserves and
expected returning from the alternative use.
It is advisable to insure those risks which are of very high potential although
the frequency is very low because it may bankrupt the organization if it
handled through the internal contingency fund.
Self insurance plans have the following advantages:
1.
Improved loss prevention incentives.
1.
No provision for agents/broker's commission, insurer's administrative

costs and profit
margin hence expenses are minimum.
2.
Interest on investment of funds is of insured's asset which may

increase or decrease
as per contribution to the fund.
2. Improve claims settlement procedures as no dispute regarding

settlement of claims.
Unit 10
Retention
5. Profit from the funds belongs to the insured.

Although a business receives some advantages, some disadvantages are also there which
are as follows:
1.
Catastrophies as well as number of losses during the year may bankrupt the
organization.
2.
Insurer provides valuable services in the form of advice on loss prevention, salvaging
and claim settlement. These services should be purchased from outside if self insurance
is preferred.
3.
A competent personal should be appointed from outside for administration of the self
insurance program. This cost should not be incurred if the risk is transferred
4.
It is not advisable to assume a risk before the financial arrangement is completed and
the funds are available for the payment of loss.
5.
Contribution towards the funds is not qualified for tax benefit.
Risk retention, deliberately or unplanned, should not be confused with the concept of self
insurance. Although self insurance requires risk retention, it implies to combine a number
of its own similar exposures to loss sufficient to predict the losses accurately. Further it
implies that adequate financial arrangements made in advance to provide funds to pay for
losses. Unless payments to the self-insurance fund are calculated scientifically and paid
regularly a true self insurance systems does not exit.
Self insurance plans are distinguished from other insurance operations by having the transfer
of risk and redistribution of the costs of losses takes place within one business entity.
Jg$ Activity D :
List out four points on "Unless payments to the self-insurance fund are calculated scientifically
and paid regularly a true self insurance systems does not exit."
10.6 CAPTIVE INSURANCE COMPANIES

The next step of internal funding is the formation of captive insurance companies
with additional advantages and benefits.
Definition of captive:
Commercial or industrial concerns establish an insurance company to insure or
reinsure risks emanating from its owner, subsidiary and associated companies.
There are a number of reasons for the formation of captive companies which are as
follows:
1.
Internal funding of risks
2.
Saving on insurance costs
3.
Risk control
4.
Assess to reinsurance market
5.
Flexibility of operations
6.
Global insurance arrangement
7.
Off shore tax havens
We will see these points briefly :

1.
Internal funding of risks

Premium paid to captive are qualify for tax benefits for its parent company,
fellow subsidiaries and associated companies as the same way as to pay
insurance premium. Transfer to reserves for unexpired risks and outstanding
claims are taken into account while calculating taxable profits which gives a
significant tax advantages over internal contingency funds.
2.
Saving on insurance costs

The are expenses are nil for marketing and sales if the business is acquired
from parent organizations, which otherwise includes in the premium of the
insurance companies. Earnings on investments belong to the captive. Claim
settlement is without any delay and any profit generated belongs to the captive
only.
3.
Risk control
Due to retaining risks captives get automatically and directly benefits from
any improvement in its loss experiences due to saving in the claim costs.
I-
Unit 10
4.
Retention
Assess to reinsurance market

By building up substantial reserves, the captives have easily assess to reinsurance
market and offer cover for excess of loss with substantial deductible, calculate the
premium on client's direct loss experience and flexible underwriting for unusual risks.
5.
Flexibility of operations
Captive can offer conditions which suit their parent companies regarding timing for
payment of premium, interpretation of policy conditions and handling of claims as
they are not bound by tariff regulations. They can also provide cover which is not
easily available in the market for example product recall.
6.
Global insurance arrangement

Risk handling strategies is different in multi national companies and policy adapted is
difficult in different countries and because of this local insurer is required to insure
domestic risks. Captive controls the local insurers and reinsure the risks write with
the captive.
7.
Offshore tax havens

Tax haven is that levies a significantly lower rate of corporation tax than the country
of domicile of the parent company. Hence although parent company will have to pay
its going rate of tax on profit remitted by the captive, until they are they will be subject
to a lower rate of tax so captives funds built up rapidly.
Advantages are discussed in the next unit.
Legislation in India does not permit setting up of Insurance Captives.
Âctivity E:
Discuss the benefits of formation of Captive Insurance Companies.
10.7 SUMMARY
We have discussed the process of risk retention which proves one of the effective tool of
risk management. Retention may be deliberate decision or it may be compulsory in the
form of deductibles. Retention is basically applicable when loss probability is low and loss
severity is also low.
We have also discussed way s of risk financing by 1. Charging losses to operating costs
2. Setting up contingency (self Insurance) funds 3. Use of captive insurance companies.
Each method has its own peculiarity.
Charging losses to operating costs depends upon the surplus and liquidity available with
the organization. Setting up contingency (self Insurance) funds is a decision of the organization
to retain losses internally which are too large and unpredictable. While captive insurance
companies are formed for additional benefits and advantages.
10.8 KEYWORDS
________________________________________________________________
Retention is a risk treatment method.
Firstly when the exposure or risk are of either very low probability or of very low severity
the effect of such losses on either the property or business continuity are so low that it
could be easier for the firm to retain such losses on its books.
Retention can also be used where the cost of transfer to insurance and similar tools is more
expensive than the effect of retention itself.
Deductibles (otherwise called excess or franchise).
What these mean is that for each and every loss for which a claim is made on the insurer,
the insurer expects the insured or the claimant to retain a certain extent of loss and pays
only the balance.
i.
Under which circumstances does it make sense to retain risks ?
ii.
Use the Loss Matrix in the annexure of Chapter XI and explain which is betterretention or buying insurance.
174
11.1 INTREDUCTION
We have discuss how the risk management makes an effective contribution to
achievement of corporate objective and helps to take a proper decision
regarding risk transfer and ultimately arrive at the decision that INSURANCE is
the best solution for transfer of risk. While insurance has been the most popular
and oldest form of risk transfer.
But it is observed that the incidences of catastrophes insurances which cannot be
covered by the traditional technology of insurance and reinsurance. The service
sectors like banking and insurance have been prepared for the world wide
fundamental economic changes with new mechanism or technology called
ART (Alternate Risk Transfer).
11.2 BACKGROUND OF ART
The happenings in the rest of the financial services industry as well as more acute
awareness of having holistic Risk Management programmes has led to
discovery and use of other forms of risk transfer. ART (Alternate Risk Transfer)
has become the topic of discussion in the Board Rooms across the world.
s
Quite often, in the last five decades, there have been occurrences of such
catastrophic nature that insurance had failed to serve as a very reliable method of
Risk Transfer. Hurricane Andrew, the Cyclone, which devastated Florida, US A in
1992, caused economic losses of US$ 30 Billion and insured losses of US$ 17
Billion. Similarly, the Earthquake in California in 1994 caused economic losses of
US$ 44 Billion and insured losses of US$ 15.3 Billion. Back home.
The earthquake in Gujarat in January 2001 reported almost 20,000 deaths. The
economic loss was put at US$ 4.5 Billion with insured losses in the range of US$ 100
Million (compare the ratio of insured losses as against economic losses in these
two parts of the world - US and India. This gives the level of insurance
penetration in both the parts).
These losses are losses, which would otherwise be called as Acts of God. There
have also been manmade disasters like that of September 11th and the rebels
on the Colombo airport destroying almost 14 aircrafts. As you would be studying
or having studied already, insurance ultimately also has to be on commercial
lines and therefore has to produce investment returns for the stakeholders. With
this kind of enormity of losses, insurers world over are struggling to find moneys
to pay these losses.
If the losses exceed the capital and reserves of insurers, then many of the insurers
will go bankrupt. Even if the remaining insurers charge hefty premiums, still the
capacity for bearing
, even it it i& pooled from all over the world, will be still well below the money required
for, one single catastrophe. Like in every other business, there are always demand
-supply equations and also business cycles resulting in alternating cycles of low returns and
high returns on investments.
jgT Activity A;
List out the points on "Need for Alternative Risk Transfer."
11.3 FAILURE OF INSURANCE AS A SOLE RISK TRANSFER

MECHANISM________________________________________________
In the preceding paragraph, we had mentioned that Alternative Risk Transfer methods are
being discovered and used. What are the reason for which insurance had failed to live up?
1.
The kind of losses, which are being faced by insurers, either out of natural catastrophes
or out of manmade disasters is so great in magnitude.
2.
The frequency and severity of these catastrophic losses are alarming but particularly
whether losses are occurring with increased recurrence.
3.
Insurers world over have limited capital. This capital is deployed in the hope that
after paying for all the losses, insurers will be left with some surplus to take care of
their management expenses and desired profit levels .If this does not happen then
there is no proper return on capital employed and therefore insurance as a avenue for
investment will lose its attraction.
4.
Insurers are witnessing for the first time, occurrences like Nine Eleven, the probability
and the magnitude, of which were simply unimaginable.
5.
Insurers have always been balancing their technical losses with income from their
investments they make in stock markets, bond markets and other areas of investments.
Over the years with declining interest rate and poor economic conditions the world
over, the Return on Investments in these areas has also been coming down. Therefore,
there is no more balancing possible.
For all these reasons there has been diminishing of capacity for insurers to carry risks.
Therefore, the faculty of risk management had to resort to solutions from other than insurance.
Âctivity B :
Comment on "Insurance industry cannot cope up with the situation created by natural
calamities."
11.4 ART
The abbreviation ART stands for 'Alternative Risk Transfer.' Particularly for large
corporations, which are the order of the day today, risk management does not simply
mean buying traditional insurance. With many 'uninsurable' risks emerging as also because
of the limitations imposed by insurers, Risk managers had to find alternate sources of
financial protection.
The incidence of unlimited catastrophe insurance loss has made the underwriters look for
ART technology to create more capital and more financial strength. So the insurer, bankers
and investors have come together with their roles in the risk transfer technology for their
mutual benefits.
The earthquake, hurricane, flood and other natural catastrophic perils and their ever
increasing exposures have brought some revolution and break traditional reinsurance practice
for the purpose of increasing the financial capacity to cover these uncontrolled, unlimited,
unexpected catastrophic exposures which is beyond the capacity of Insurance, Reinsurance,
and Network capacity. This inadequacy ART came into existence.
The term ART was mainly used to describe various forms of self- insurance, pools and
Finite Risk covers. ART as it stands today includes not only captive insurance companies
but also extends to the areas given below:
Industry and exposure specific mutuals.
Large direct corporate retentions.
Unit 1 1
Emerging Trends in Risk Management
Programs from insurers that involve commitment of capacity often across lines of
coverage and across several years.
Environmental liability and credit risks.
Holistic financials of risk.
Basket aggregate.
Risk retention groups.
Insurance derivatives.
Blended programs.
Loss portfolio transfers.
Across class, aggregate programs.
ART products are long term contracts as against annual contracts in insurance and
reinsurance arrangement.
ART covers entire portfolio of risk with adjustments and returns to the Investors.
The variety is amazing but for the limited purpose of discussion, we shall be looking at only
few specific ART solutions :
C:
Write down few points on scope of ART taking into account the current natural calamities,
man made loses such as floods in Mumbai and Gujarat, bomb blasts in Maharashtra, etc.
in India.
11.5 CAPTIVE INSURANCE COMPANIES

Large corporations particularly spreading over many countries and continents, have a
substantial need for a very effective risk management. By adopting an external supply of
risk transfer these corporations are still subject to the vagaries of insurance markets. For
reasons mentioned in the previous paragraphs, insurers can not provide all risk solutions.
178
Therefore large conglomerates resort to creating what are called as Captive

Insurance Companies. These are special purpose insurance outfits created to
cater to the needs of the parent or group companies.
1. The advantages of using Captives are as follows:
a)
The risks of the parent or group companies are taken off their balance
sheet and
moved to the captives.
b)
The captives provide an arm's length comfort for transferring risks and
preferring
and getting claims.
c)
Captives themselves insure their risk portfolio with Reinsures.

Therefore they
also aim at having stabilized financial performance over the years.
d)
Any surplus produced by the captives provides the promoters, a

Return on
Capital employed.
e)
Most captives are located in Tax Havens. Certain territories like

Bermuda,
Guernsey Islands, Singapore, all provide substantial ease of
registration and
operation of captives. These territories also provide a variety oftax
benefits
including exemptions. These benefits in turn go to the parent company.
f)
Captives are dedicated to their parent or group. Therefore they can

provide
customized solutions to these customers. The other way round,
captives also
have assured customers. The normal friction, which can take place
between
two uninterested parties, is reduced because of the special
relationship.
Hence captives are a very popular form of risk transfer. As of now there are
more than 2300 captives all over the world.
xgTActivity D :
Justify the statement "captives are a very popular form of risk transfer."
Unit 11
11.6 SECURITISATION
It
seems
that
insurers suffer from lack of funds. Other investors in capital markets sometimes find
lack of proper avenues for investment. There are major catastrophes either
natural or man-made recurring in a period of time. Put all these three together
and you will find that there is scope for what are called as Securitisation of
Insurance Risks.
Transfer of risks in insurance market to investors in the capital market is done
through Securitisation to cope up with the incidence of huge catastrophic
losses and avoid their consequent insolvency, In simple terms, Securitisation,
provides access to the Insurance business for capital market investors without
actually running an insurance company.
These investors are not insurance exports or underwriters. They simply invest for
Insurance Company through capital market. Investors in ART products are
Corporate Financial Institutes, Mutual Funds and Banks.
Insurance Securitisation involves the process of transfer of property and
casualty risks from insurer to the investors with the issuance of a security, the
ultimate returns depends upon the occurrences of catastrophic events and
reference of performance index.
We will now look at a recent example for understanding this better. Disneyland
Tokyo, a subsidiary of Disney group of USA, when they were to setup the
Theme Park in Tokyo, they faced a major concern on the earthquake proneness of
the location. While conventional insurance covers could have still been available,
the cost and the limitation proved a problem for Disneyland.
Therefore, they issued what are called as Catastrophe Bonds for Earthquake for
the value of the US$ 100 million. These Bonds carry a coupon rate or what is
an equivalent of interest paid on bonds. The purchases are investors from the
Capital Markets. The bonds operate in such a way that if any earthquake
happens in area where the Theme Park is located, then all losses due to
earthquake would be paid for by the bond holders. These bonds have limited
tenure and therefore if no earthquake losses happen on during the tenure of
the bond then the bondholders earn all their coupon rates and incur no losses
whatsoever.
An added advantage to the investors is that these bonds are liquid in that
they can be traded. Catastrophic bonds have really caught up the fancy of
investors as well as insurers that the have been hundreds of such bonds issued
as of now.
179
Jg$~Activity E:
Write your opinion on "ART brings the convergence of insurance markets with capital
markets by way of securitisation."
11.7 FINITE RISK PRODUCTS

Another major development in the development of ART products is Finite Risk products.
Currently, most of them are used more for the benefit of insurers rather than the insured.
These are multiline products in the sense that they cut across several classes of insurances
like Property, Casualty and Liability. These are also multi year products as contrasted with
annual contracts.
Finite Risk Products derive their terminology from the fact that the ultimate liability of the
provider of this facility is limited at a particular financial level. It is more of a participative
program wherein the provider as well as the customer, share their experience of the loss
history over a period of time. If the loses are minimal or controllable and any surplus
emerges then it is shared between the provider and customer in the form of profit
commissions.
For example, if the loss limit agreed was Rs. 100 crores over a 5 year period, but losses
didn't exceed let us say, Rs. 60 crores in this period, then the provider of this product and
the user, share this surplus in the form of certain amount of premium paid by the user to the
provider being returned as profit commission. In the same manner, the reverse also holds
good. If the losses exceed a certain pre-agreed level then additional premiums have to be
paid by the customer to the provider.
Swiss-Re, one of the major players in the field of financial reinsurance, observes that the
main functions performed by finite risk products are:
A. Smoothening of fluctuations of the customers' loss experience over a given period.
B.
Optimization of balance sheet structure although finite risk products were largely
used by insurance companies of late even companies in non-insurance sectors have
found them useful.
Unit 11
Âctivity F:
Explain how the Finite Risk Products are more beneficial to the insurer than the insured.
11.8 DERIVATIVE PRODUCTS______________________________________

Normally derivative products are, as the name implies, derived from certain core financial
service products. Particularly when the core product in question is of volatile nature, then
derivatives help the user of such products to smoothen out the effects of such wild fluctuations.
To draw an example from the capital market, the exchange rate between various currencies
is again a highly speculative risk area. Large volume users of foreign exchange have to
protect themselves against volatilities of exchange rates, then they resort to the derivative
products. The derivative is linked to these dollar value and if the dollar-rupee exchange
rate fluctuates above a certain pre set limit, then the provider of Derivative services
compensates the user for such over shooting.
Which means that the risk of huge increase in exchange rate is transferred to the service
provider for say a fee or premium: Generally, traders in large volume of exchange related
businesses hedge their risks in exchange rates with such derivatives? Similarly, for a portfolio
of insured risks or even for a single risk, any customer, even insurers can protect themselves
against fluctuations in the performance of the risk. One such possibility is, that linking the
performance of a risk, to the index of the performance of similar risks.
To understand it better, let us look at the portfolio of risks comprising Oil refineries which
refine crude oil for producing finished petroleum products like petrol, diesel, etc. Either
the refinery owners or insurers of certain refineries can protect themselves through a
derivative product linked to the loss history of the pool of let us say about 100 refineries.
If the loss percentage of a particular refinery exceeds the general performance of the pool
of refineries then such excess exposure will be compensated by the providers of the
derivative product. Obviously, similar to the premium paid by a customer to the insurance
company, the same way, a fee has to be paid for the derivative products. By doing this the
customer or the insurance companies ensure that their losses are not adverse.
182
Âctivit y F;
How the derivative products helps insurance companies so that loss ratio should
not be adverse.
11.9 DEVELOPMENT OF ART IN INDIA
Art products have not found significant place in Indian Insurance Industries.
Recently IRDA is set to allow insurers to invest in interest derivatives to
hedge risks in order to ensure that their future liabilities do not exceed their
assets.
Re insurance protection for catastrophic losses arising from single event is not so
large so at present Indian General Insurer does not find much difficulty for re
insurance protection. But in future due to increasing operations of B
ANCASSURANCE by General Insurance companies, introduction of credit
insurance by state owned companies like New India Assurance and prospect
of Agriculture Insurance have the potential of Rs. 50000 crores in India, so there
will be need of ART products in Insurance Industry in near future.
As per recent IRDA regulations on solvency margins for insurers, reinsurers,rising
market expectations for more efficient risk financing programs and revolutionary
development of Indian Capital Market to the world class standard are all
including factors for insurers, reinsures and bankers to make proper use of
essential ART products of transfer of insurance risks from insurance market to
capital markets for wider capital base with minimum cost
Â ct ivit y G :
Express your views on "Use of ART products is essential as India is going to
be the economic power house in the world with growth in all sectors including
insurance sector."
Unit 11
11.10 SUMMARY
Dr. Alan Punter who specializes in Alternative Risk Transfer products summarizes the
emerging trends as follows:
ARTs extend the range of risk covered beyond the traditional property- casualty
hazards to include other non-core risks to the company's business. These include
how to insure risks such as environmental exposures and financial risks such as foreign
exchange rates, interest rates, stock market prices and commodity prices.
Extend the period of cover beyond the normal one-year insurance to multi year
contracts to provide greater stability.
Provide holistic or enterprise wide covers from a client's perspective.
Provide risk-financing instruments that respond with greater speed, clarity and security.
These represent the demand side of the ART process.

On the supply side Dr. Punter feels that there are certain factors that will continue to drive
the development of ART:
Consultants and intermediaries, some outside the traditional insurance industry such
as Management Accountants and Investment Bankers are seeking to expand their
involvement in all aspects of Corporate Risk Management and financing.
Investors are always interested in new opportunities particularly in a low or a noncorrelated asset class like insurance.
Alternative solutions and capital will advance so that whenever there is a contraction
in the supply of traditional reinsurance capacity due to either cyclical or catastrophic
losses.
This in effect sums up the developing trends in ART industry. As traditional insurers, one
can expect the dividing line between insurance and non-insurance financial services to get
thinner and thinner.
11.11 KEYWORDS
Alternative Risk Transfer (ART)
Are non insurance methods which offer risk

transfer solutions.
Captive Insurance companies
These are special purpose insurance outfits

created to cater to the needs of the parent are
group companies.
Securitisation
In simple terms, securitisation provides access

to the Insurance business for capital market
investors without actually running an insurance
company.
Finite Risk Products
These are multiline products in the sense that they

cut across several classes of insurances like
Property, Casualty and Liability. These are also
multi year products as contrasted with annual
contracts. Finite Risk Products derive their
terminology from the fact that the ultimate liability
of the provider of this facility is limited at a
particular financial level.
Derivatives
From certain core financial service products.

Particularly when the core product in question is
of volatile nature, then derivatives help the user
of such products to smoothen out the effects of
such wild fluctuations.

In the previous unit, when you were addressing the Chamber of Commerce, you were
explaining the benefits of Insurance. Do you still stand by our statements? If not, can you
elaborate why?
List out some of the ART tools.
What are the advantages of setting up a Captive Insurance Company?
Do you think India needs products like derivatives?
Given the poor Insurance penetration in our country, is conventional insurance better or
ART? Analyse.
1.

Risk Management G Insurance

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Risk Management in General Insurance

Risk management as a subject and as a function function of businss management and

1.2 NECESSITY OF RISK MANAGEMENT

Basic Concept of Risk Management

1.3 IMPORTANCE OF RISK MANAGEMENT

Risk Management in General Insurance

1.4 DEFINITION OF RISK

Risk is the possibility of an unfortunate occurrence.

Risk is a combination of hazard.

Risk is uncertainty of loss.

Risk is the possibility of loss.

Basic Concept of Risk Management

1.5 RISK, PROBABILITY AND UNCERTAINTY

Risk Management in General Insurance

500 (Rs. Crores)

Fig 1 : Total Losses in a financial year

500 (Rs. Crores)

Fig 2 : Total Losses in a financial year

Basic Concept of Risk Management

Risk Management in General Insurance

Uncertainty is a person's conscious awareness of the risk in a given situation. It

Basic Concept of Risk Management

1.6 CLASSIFICATION OF RISKS

Risk Management in General Insurance

Basic Concept of Risk Management

Write down four examples each of pure and speculative risks.

1.6.2 Dynamic Versus Static Risks

Risk Management in General Insurance

1.6.3 Fundamental Versus Particular Risks

1.7 CLASSIFICATION BY SIZE OF LOSS

Basic Concept of Risk Management

Class III - Larger losses which might bankrupt the firm.

1.8 OTHER TYPES OF RISKS

Risk Management in General Insurance

Basic Concept of Risk Management

1.9 TYPES OF RISKS REQUIRED TO BE MANAGED

Risk Management in General Insurance

A scientific approach to the problem of dealing with the pure

The probability associated with a certain outcome is the relative

It is the conscious awareness of the risk in a given situation.

It is the variation in the outcome that could over a specific

Pure risk is where there is a chance of a loss but there is no

is where there is a chance of gain.

arises due to.economic, social, political, environmental and

are exists in the absence of such changes.

are much more personal both in cause and effect.

Risk Management in General Insurance

The Process of Risk Management

2.4 COST OF UNCERTAINTY ITSELF (INDIRECT LOSSES)________________

Risk Management in General Insurance

2.5 PRIVATE AND SOCIAL COSTS

The Process of Risk Management

2.6 THE RISK MANAGEMENT PROCESS______________________________

Identify all significant risks

Evaluate potential frequency and severity of losses

Develop and select methods for managing risks

Implement risk management methods chosen

Control on the performance

Risk Management in General Insurance

Physical, social and legal environment

Study of past records etc.

Example : Risk is depends on type of construction of a building, Location of the

The probability or chance that the losses will occur.