Risk

Part I- Module 1 Risk & Insurance

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What is Risk & Types of Risk

What is Risk????

• Results not as per expectation-here returns• Unexpected negative phenomenon or• Expected positive phenomenon not

happening

Types of Risk

• Systematic risk-non diversifiable-is one which effects on the market as a whole-inflation ,political ,monsoon vagaries.

• Unsystematic risk-diversifiable-individual business, new technology, management expertise, capital structure. line of business activity.

Types of risks

• Capital risk• Interest rate risk• Liquidity risk• Credit risk• Inflation risk• Currency risk• Risk of not taking risk• Country risk

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Types of Investment Risks

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Risk

• Total risk = General risk + Specific risk = Market risk + Issuer risk = Systematic risk

+ Nonsystematic risk

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Degree of Risk• Every investor needs to find his or her comfort level with risk and

construct an investment strategy, with the help of a financial planner, around that level.

• There is no “right or wrong” amount of risk – it is a very personal decision for each investor.

• However, young investors can afford higher risk than older investors can because young investors have more time to recover if disaster strikes.

• If an investor is five years away from retirement, he probably would not want to be taking extraordinary risks with his nest egg, because he will have little time left to recover from a significant loss.

• However, a too conservative approach may mean the investor will not achieve his financial goals.

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Standard Deviation• Standard deviation or variance is used to calculate the total risk

associated with the expected return• This is a measure of the spread or dispersion in the probability

distribution; that is, a measurement of the dispersion of a random variable around its mean.

• The larger this dispersion, the larger the variance or standard deviation.• Also, the larger the standard deviation, the more uncertain the outcome. • Standard deviation is square root of variance, where variance = Sum of

{Probabilities*(actual return-expected return)2}.• The standard deviation of return measures the total risk of one security

or the total risk of a portfolio of securities.

Risk of a portfolio

• In a portfolio of different securities-returns would depend on return on individual securities as well as weightage of each security

• It can be calculated by considering the sd of individual securities as well as interactive risk among securities, measured by covariance

Covariance

• Is a Measure whether 2 set of returns (securities) move together or opposite direction.The statistical measure of co-variance is correlation coefficient.

• Assets which move in exactly opposite direction all the time are said to be perfectly –vely correlated & have correlation coefficient of -1

• Same direction +1 & no relation 0..helps in asset allocation. putting money in –ve correlated sectors.

Beta

• Beta is the measure of sensitivity of a stock-security in relation to market-benchmark.

• It could be less than or more than one.• Beta is the market risk of a security.

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Expected ReturnsAssuming equal probability, and with closing pricing of a stock for the previous years calculate

the expected price of the stock for the current year..• Stock A

– Year 0 : Rs 100– Year 1 : Rs 120– Year 2 : Rs 80– Year 3 : Rs 110– Year 4 : Rs 100– Year 5 : ?

• Stock B– Year 0 : Rs 100– Year 1 : Rs 90– Year 2 : Rs 120– Year 3 : Rs 110– Year 4 : Rs 100– Year 5 : ?

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Expected returns – Use XL to calculate

Probability A B

0.2 100 100

0.2 120 90

0.2 80 120

0.2 110 110

0.2 100 100

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Which Stock?

• Risk & Return For Stock A• Risk & Return For Stock B

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Stock which has less variation from the expected price, because we

want to be sure that we get closer to what we want

We use standard deviation to find which stock varies less from the expected return..

Meaning which stock is less risky..

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Standard deviation

• Variance= Sum { Probability * (actual return – expected return)2 }

• Standard deviation = sq root of variance

• Higher Standard Deviation means higher risk and Lower SD = Lower Risk against its average

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Work out the standard deviation?

Probability Returns

0.2 15%

0.3 18%

0.3 10%

0.2 8%

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SD – solution (Use-XL to calculate)

Returns Actual returns – exp returns

Difference squared

Probability

Diff sq*probability

15 2 4 0.2 0.8

18 5 25 0.3 7.5

10 -3 9 0.3 2.7

8 -5 25 0.2 5

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S. D. Solution

• The sum of the last column is 16 which is the variance

• Square root of variance is standard deviation = 4

• Standard deviation in this case is 4%• The lower the standard deviation the better

are the chances of getting the expected returns

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Expected return - portfolio

• Let’s consider a portfolio with two securities A and B with a weight of 60% assigned to A and 40% to security B. If the following are the probabilities of return for individual securities A and B let us try and find out the probable return on the portfolio:

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Expected return - portfolio

Probability Probable return on security A

Probable return on security B

0.15 25% 30%

0.2 15% 20%

0.3 0 5%

0.2 -5% 0

0.15 -10% -10%

Risk Management

AvoidanceReductionRetentionTransfer

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WHAT INFLUENCE RISK – TIME

• The objectives being pursued may require a policy statement that speaks to specific planning horizons.

• In the case of an individual investor this could be a year or two in anticipation of a down payment on a home purchase or a lifetime, if planning for retirement.

• Generally speaking, the longer the time horizon, the more risk can be incorporated into the financial planning.

• A financial planner has to take into account the time horizon while structuring investment portfolios and the general rule is younger a person is, longer can be his time horizon, and hence more exposure to equities.

• Time has a different effect when analyzing the risk of owning fixed income securities, such as bonds.

• There is more risk associated with holding a bond long term than short term because of the uncertainty of future inflation and interest rate levels.

Risk ManagementDIVERSIFICATION• Most common tool for risk management is

diversification .Diversification can be • Risk Reduction through Product Diversification

( ASSET ALLOCATION)– Across-asset class-debt, equity ,real estate and

various alternative asset class– Across –geographies- BRIC, USA , UK– Across different industries & securities-stocks

• Risk Reduction through Time Diversification ( SIP)

Time diversification

• Generally speaking longer the time frame longer risk can be incorporated in a portfolio or plan- younger a person more exposure to equities

• Rupee cost averaging.• Time has diff effect when analyzing the risk of

owning fixed income securities-there is more risk in holding bonds for longer term bcos of uncertainty of inflation & Interest rates.

Risk Management

• Risk Avoidance • Risk avoidance is accomplished by not

engaging in the action that gives rise to risk. Avoiding risk is an

• Appropriate strategy for high frequency and high severity risks.

Risk ManagementRisk Retention• Risk retention is used when the risk is retained. The

retention may be voluntary or involuntary. • Appropriate strategy for low frequency and low

severity risks. For example, the risk of suffering from common cold can be retained. As a general rule, risks that should be retained are those that lead to relatively small certain losses.

• The reason for retention is because there is a cost attached to transfering,reducing or avoiding risk. It may be more cost effective to retain the risk since its frequency as well as impact is low.

Risk Management

Risk Transfer• Risk transfer is the transfer of risk from one

individual to another who is more willing to bear the risk.

• Insurance is the most widely used means for reducing risk by transfer. Risk transfer is appropriate for low frequency and high severity risks.

Risk & Insurance

Part II- Introduction to Insurance

Strategies to Manage Risk

• High Frequency and High Severity – Avoidance• High Frequency and Low Severity-

Reduction( taking measures of control /precaution)

• Low Frequency and Low Severity – Retention• Low Frequency and High Severity - Transfer

Risk & Insurance- Transfer of Risk

• Risk is the possibility of harm, injury, loss, danger, or destruction.

• What causes risk – Perils & Hazards – Peril is one cause of a loss. We refer to the peril of

Fire, Burglary– A Hazard, on the other hand is a condition that

may create or increase the chance of loss – arising out of the given peril.

Types of Hazards

• Physical Hazard

• Moral Hazard

• Morale Hazard

Pure risk is used to designate those situations that

involve only the chance of loss or no loss.

Life Insurance -Personal Risks• Personal risks are those risks that directly affect

an individual. They cause financial insecurity because they usually result in a reduction or stoppage of income, an increase in expenses and a depletion of financial resources.– Risk of premature death– Risk of poor health– Risk of temporary or permanent disability– Risk of insufficient income during retirement

Insurance

• Insurance is defined as an economic device whereby the individual can substitute a small definite cost (the premium) for a large uncertain financial loss (the risk)

Insurance features

• Pooling of Losses• Works when :

– Large numbers– Definite & Measurable– Accidental /fortuitous & – Not catastrophic

Benefits

• Indemnification of loss• Reduction of anxiety• Source of funds• Loss prevention• Enhancement of credit

Costs

• Cost of conducting business• Inflated claims• Fraudulent claims

Basic parts of LI contract

• Parties• Promises• Premium & sum insured-death benefit• Exclusions• Conditions• Deductibles• Riders• Co insurance

The Insurance contract

• Offer-acceptance• Consideration• Competent parties• Common intension-meeting of

minds:consensus ad idem• Legal purpose

Distinct Contract

• Aleatory contract - are those where the value exchanged is not equal but depends on an uncertain event

• Unilateral contract- Unilateral contracts are those in which only one party makes a legally enforceable promise. In the case of

insurance contracts only the insurer makes that promise.• Adhesion contract- Contracts of adhesion are those that

must be accepted in toto, with all their terms and conditions. In insurance contracts this means that the insured must accept the policy issued by the insurer as it is. The insured cannot insist on any changes or modifications to the contract.

Insurance Contract

• Conditional Contracts- Conditional contracts are those which place certain restrictions or limitations on one or both parties. In insurance contracts the insured must comply with policy conditions if he wants to collect payment for his claims. In case of non-compliance of the policy conditions the insurer can refuse payment.

• Personal Contracts - This means that the policy is personal to the insured. With the exception of life insurance, it may not be assigned to anyone else without the approval of the insurer.

Parts of Insurance Contract

• Preamble or Recital Clause• The operative Clause• The Attestation Clause• The Policy Conditions and Schedules

Parts of Insurance Contract

• Preamble -The preamble of the policy states that the proposal and declaration, signed by the party, form the basis of contract. The form contains a schedule which gives all essential particulars of the policy like name, address, plan of insurance, premium, amount of insurance, etc. On the back of the policy, the standardized terms and conditions applicable to all persons insuring under a particular plan are printed. Any special conditions imposed, are indicated by endorsement.

• Days of grace :Days of grace or grace period is the ‘extra time’ given to the policyholder for payment of installment premium after the due date, during which the policy remains in force. It is normally provided for a period of a fortnight to a month. Grace period is meant to be a convenience to the policyholders, some of whom may not be able to pay the premiums on time due to certain preoccupations etc.

Terms in Insurance Contract

• Revival of Policies :A lapsed policy can be brought back to life through revival, as if it is a fresh contract, subject to certain restrictions with regard to the period of lapse etc. The policyholder may however be required to submit a fresh set of medical and other requirements/declarations at the time of revival. For the purpose of a claim too, the policy may be treated as new and Sec.45 of the Insurance Act, 1938 be applied.

• Surrender and Paid up Value :Sec.113 of the Insurance Act provides for accrual of certain benefits to policyholders even if they are unable to keep their policies in full force by payment of further premiums. If premiums for at least three consecutive years have been paid, there shall be a guaranteed surrender value. If the policy is not surrendered, it shall subsist as a paid up policy for reduced sum. The policy conditions usually provide for a more liberal surrender value and paid up value, than those secured by the statutory provisions.

• Policy Loans :When a financial contingency arises a Policy Loan is a ready source of borrowing to a policyholder, It is paid by insurers against the surrender value accrued to a policy. Policy loans lend liquidity to contracts which are otherwise ‘frozen’ during the term of the policy.

Insurance Contract• Non-Forfeiture Regulations :Non-forfeiture regulations provide

succour to policyholders who are unable to pay premiums due to temporary financial difficulties. Non-forfeiture regulations allow additional time of, say, six months or a year for payment of premiums on a policy, even as the risk under the policy continues to be covered. Insurers offer this privilege after the policy has been in force for a few years and is not offered on term assurance and some of the ‘high risk cover’ policies.

• Riders: It is possible to tag-along coverage of additional risks to the basic life product on payment of additional premiums, subject to certain conditions and restrictions. Such add-ons like accident riders, critical illness riders, premium waiver riders in case of minor life policies etc are quite popular

• Suicide Clause :As per Indian law suicide is not a crime, but attempt to suicide is a crime, unlike in English law where suicide is a crime. Hence, contracts of insurance that agree to pay the sum assured even in the event of the death of life assured due to suicide are not against public policy. But, to avoid a possible moral hazard and adverse selection, insurance companies do place a restrictive clause by not covering death as a result of suicide up to one year from the date of commencement of policy or date of issuing of policy, whichever is later.

Insurance Contract

• Pregnancy Clauses :On life insurance policies issued during the pregnancy of a female proponent, life insurers apply this clause to exclude coverage of pregnancy / child birth related deaths.

• Specific clauses on female lives :Certain classes on female lives such as females in the age group of 20-35 who have no earned income are susceptible to moral hazard. To avoid this risk, insurance companies do impose these clauses excluding coverage of accidental death in other than public places

• Occupation related clauses :To exclude the risks that are closely related to the occupation (like that of a pilot whose occupation is prone to aviation risks) of the life assured, insurance companies do levy these clauses excluding the risk coverage owing to the death of the life assured during the course of employment. Ex: Aviation clause,Divers’ clause.

Insurance Contract

• Lien Clause :In respect of certain types of high risk life insurance policies where insurers have a lower level of comfort due to the adverse disclosures made in application for life insurance and where insurance coverage cannot be denied based on such disclosures, life insurance companies do impose the lien clause which could either limit the liability of the insurer during a specified period [like 50% of sum assured during first year,75% in the second year and 100% from the third year onwards]; or defer the coverage for a specified period [like no life cover during first year of the policy].

• Life insurers also reserve the right to impose a clause during the term of the policy through a clause based on the future occupation that a minor life may engage in. Under the current clause, insurers require the minor life to notify them in the event of minor life engaging in hazardous occupations. On receipt of information from the life assured on his reaching the majority or on his joining the services of hazardous occupations, life insurers may apply such occupational clauses as deemed necessary. Hence, policies issued to minor lives, will be subject to these clauses.

Insurance Contract• Endorsement : is an attachment appended to the policy

document itself effected to amend the terms of conditions in the original policy.For example: Assignment or transfer of a life insurance policy may be made by simply making an endorsement to that effect in the policy document.

• Nomination• Assignment

• Inconstable Clause

Other Provisions

• Spes successionis :This phrase means “hope of succession”. The principle of insurance law is that only a person having an insurable interest in the subject matter of insurance can seek and sustain any right in an insurance policy. Any hope of succession or any expectation of stepping into the shoes of the assured cannot give a locus standi to a third person to sustain a proceeding in matters related to insurance proceedings.

• Pari Delicto :The phrase signifies that both parties are equally blamed. This doctrine is applicable on issues involving return of premium. The general rule is that where a policy by existence is an illegal policy, the premium cannot be recovered or returned. It has to be proved that both the parties are in pari delicto for an insurance company to avoid a return of premium.

• Salus populi est Supreme Lex :This principle means that the regard for public welfare is the highest law.

Other Provision

• Res ipsa loquitor :This phrase signifies that “things speak for themselves or the thing speak for itself”. The principle provides that under certain circumstances the mere fact of occurrence of an accident raises an inference of negligence so as to establish a prima-facie case.

Principles of Insurance

• Utmost good faith-doctrine of “uberrima fides”: material facts disclosure,misrepresentation,Non disclosure-Proposer of Insurance

• Insurable interest-by law, contract ,statute• Indemnity-mechanism by which insurance co.

attempts to place insured in the same position immediately prior to loss.

• Subrogation• Contribution• Proximate Cause

Principle of Insurable Interest• LI• Every person has an unlimited insurable interest in his own life. His ability to get

himself insured is restricted only by his ability to pay the applicable premium.• A person also has an automatic insurable interest in the life of his / her spouse.• A person has insurable interest in the life of debtor, but only to the extent of the loan

outstanding.

• In Property Insurance:• The absolute owner has insurable interest in the property owned by him / her.• Any person, who has partial or joint interest in some property, is entitled to insure to the extent of

the full value of the property, rather than just the extent of actual interest. In such cases he will be deemed an agent for the balance.

• Mortgagees and Mortgagors both have insurable interest. Here, the purchaser’s (mortgagor) interest arises because of ownership whereas the mortgagor’s interest arises as a creditor which is limited to the extent of the amount of loan.

• Trustees/ executors/ administrators are legally responsible for the property in their charge.• A bailee is a person who legally holds the goods of another e.g. workshops, drycleaners etc.They• have insurable interest as they have the responsibility to take reasonable care of the goods.• Where a principal has insurable interest, his agent can effect insurance on his behalf.• Spouses have insurable interest in each other’s property.

Insurable Interest -In Liability Insurance

• A person has insurable interest to the extent of any potential liability which may be incurred by way of damages or costs. For example a drug manufacturing company may incur a liability due to ill effects of a new drug.

• In liability insurance it is not possible to predetermine the extent of interest because there is no way of knowing how and when one may incur liability and what would be the monetary value of the liability.

• In practice, a realistic judgment is made by the insured about the maximum liability that may be incurred and insurance procured for that amount, unless any relevant statute has fixed some limits.

Methods Indemnity• Cash:In this method the insurance company simply pays the cheque for

the amount payable under the policy and gets discharged of their liabilities.

• Repairs:The insurers may get the damages repaired on their own, e.g. in motor insurance, the insured need not pay the cost of repairs as it is directly paid by the insurance company to the mechanic / workshop.

• Reinstatement:This method is mostly used in fire insurance for building or machinery where the insurance company undertakes to repair the damage or reconstruct the building.

• Replacement:Insurers may undertake the replacement of the damaged item e.g. a broken plate glass window in a showroom.

Measuring -Indemnity• Property Insurance:Not by the cost of the property, but by the value at the

date of loss and at the place of the loss.If the value has increased during the currency of the policy, the insured is entitled to an indemnity on the basis of the increased value. This rule is, however, subject to policy conditions such as the total sum insured etc.

• In assessing the amount of indemnity, the following are not considered:• _ Loss of Prospective Profits• _ Consequential Losses• _ Sentimental Value• Building Insurance: The cost of repair or reconstruction at the time of loss. An

allowance for betterment is deducted from the indemnity payable.• Insurance of Household Goods:Indemnity is based on the cost of replacing

items at the time of the loss, subject to deductions for wear and tear.• Two different types of covers are generally available for household goods.• _ Indemnity only• _ New for old ;there is no deduction for wear and tear. Indemnity is calculated

at replacement at current market price.

Measuring -Indemnity• Liability Insurance:• Amount of indemnity is the amount of any court award or negotiated “out

of-court” settlement plus costs and expenses arising in connection with• the claim.

Factors limiting payment• Sum insured:The total sum insured is the limit of maximum amount

recoverable under the policy even if the calculated amount of indemnity is higher. Indemnity can exceed the sum insured if the policy is not updated for a long time and in that duration the value of the property increases.

• Exceptions:At times, in marine insurance policies, some loss minimization expenses are paid even in excess of sum insured.

• Depreciation:The value of an asset decreases over time due to constant use. So the amount towards depreciation due to wear and tear is generally deducted.

• Salvage:In case of partial loss, the property may remain in a deteriorated or damaged condition. If the insurance company has agreed to pay the loss in full, it is entitled to any materials left. If the left over parts are not

• deposited with the insurance company, the amount payable is reduced by the value of salvage. This is common practice in motor insurance policies.

Factors limiting payment• Average:If at the time of loss the value of the property insured is more than the sum

insured, then the insured would be considered his own insurer for the difference. Thus in the event of loss, the amount is shared between the insurer and the insured in the proportion of sum insured and the amount of under insurance.

• Excess: An excess is the initial amount of each and every claim that is supposed to be borne by the insured himself. The objective is to eliminate the small losses which may involve comparatively high administrative cost for the insurer. Excess is of two types – Voluntary and Compulsory. Voluntary excess is voluntarily opted by the insured and results in reduction of premium whereas compulsory excess does not result in any reduction.

• Limits: Many policies limit the amounts to be paid for certain events by the wording of the policy itself. For example universal health insurance policies often specify a limit of Rs. 15,000 per claim.

• A franchise is similar to a deductible in that the insurer makes no settlement if the total claim is below the franchise figure. However, if the claim is above the franchise figure, the claim is paid in full. Franchises are very unusual in modern insurance practice though machinery breakdown covers sometimes use time franchises.

Subrogation• This principle is corollary to the principle of indemnity in the sense that it

prevents the insured to be benefited by loss after receiving the loss from the insurer as well as the responsible third party. The insured may recover the loss from another source after receiving the claim from the insurers, but, that additional money must be given to the insurers.

• Subrogation applies only when there is a contract of indemnity. It is not applicable in life insurance, personal accident insurance as these are not subject to the principle of strict indemnity.

• Definition:Subrogation is the right of one person (insurer), having indemnified another (insured) under a legal obligation to do so, to stand in the place of that other (insured) and avail himself (insurer) of all the rights

• and remedies of that other, whether already enforced or not.• Extent of Subrogation rights• This principle does not apply only to the insured but also to the insurer as

insurers are not entitled to recover more than what they have paid as claim. Just like the insured, the insurer must also not make any profit out of an insurance claim.

Contribution• In some cases more than one policy may be in force on the same subject

matter at the time of loss. In that circumstance each insurer would need to bear a proportion of loss. This is referred to as Contribution.

• Contribution is the right of the insurer to call upon others similarly (but not necessarily equally) liable to the same insured to share the cost of an indemnity payment. If an insurer has paid the indemnity in full, he can recover an equitable proportion of the risk from other insurers.

• The following features are to be met before the condition of contribution arises:

• _ Two or more policies of indemnity must exist;• _ The policies must cover the same interest;• _ The policies must cover a common peril which gives rise to the loss;• _ The policies must cover a common subject matter; and• _ Each policy must be liable for loss• It is not necessary for the policies to be identical to each other. There should,

however, be an overlap in such a manner that both policies are liable for payment of indemnity.

Basis of Contribution• Contribution is usually calculated on the basis of

‘Rateable Proportion’. This means that each insurer contributes towards paying the loss in proportion to the sums insured on the policies.

• Even if the property is underinsured, the insured is considered to be his own insurer for the uninsured amount. Thus, as per the concept of rateable proportion the insured is supposed to contribute towards bearing the loss with respect to the uninsured amount.

Principles of proximate cause• Single or last in the series cause• In the event of loss, the burden of proof is on the insured. He has to prove

that the proximate cause of loss was an insured peril.• If the insurance company argues that the loss was caused by an excepted

peril, the onus of proof shifts to them. • The doctrine is also modified by express policy conditions especially in fire

and accident policies. The condition is usually worded in a manner so that the loss caused proximately or remotely, directly or indirectly, by an excluded peril, is outside the scope of the policy.