Risk

Management
and
Reinsurance

Banking, Financial Services and Insurance Committee

The Institute of Chartered Accountants of India
New Delhi
This Publication has been prepared for use by the members of the Institute. The views expressed
herein do not necessarily represent the views of the Council of the Institute.
© THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA

All rights reserved. No part of this publication may be reproduced, stored in retrieval system or
transmitted, in any form, or by any means, electronic, mechanical, photocopying, or otherwise,
without permission, in writing, from the publisher.

Month and Year of Publication

First Edition : October, 2003
Second Edition : February, 2005
Third Edition : July, 2005
Fourth Edition : October, 2008
Fifth Edition : February, 2020

E-mail : [email protected]

Website : www.icai.org

Price : Rs. 600/-

ISBN : 978-81-8441-028-0

Published by : The Publication Department on behalf of the Institute of Chartered

Accountants of India, ICAI Bhawan, Post Box No. 7100,
Indraprastha Marg, New Delhi - 110 002.
Printed at :

This book is also a Study Material for Paper-3 of the DIRM Course of the Institute of Chartered
Accountants of India.
FOREWORD
The Insurance sector has emerged as one of the fastest developing sectors in India. Its
sphere has enlarged to the extent that requires expert and specific domain knowledge to
protect and promote the economic interests of all the stakeholders. For Chartered
Accountants, the importance of updation of knowledge is of quintessential importance.
Multi-pronged strategies are being adopted by the Institute of Chartered Accountants of
India (ICAI) to facilitate the members and students to acquire technical and practical
knowledge in the field of insurance. The ICAI through its Banking, Financial Services and
Insurance Committee (BFSIC) conducts Diploma in Insurance and Risk Management
(DIRM) Course to equip professionals with expertise and competence in insurance and
pension sectors.
It is heartening to note that the Banking, Financial Services and Insurance Committee of
ICAI has taken the initiative to revise the Study Material of DIRM Course as a measure to
provide the latest possible technical inputs to the members who are pursuing the Course.
The material has been designed to provide an in-depth and comprehensive theoretical
knowledge as well as practical aspects, in a very practical and simplified manner.
I appreciate the efforts put in by CA. Dhiraj Kumar Khandelwal, Chairman, CA. Charanjot
Singh Nanda, Vice Chairman and other members of the Banking, Financial Services and
Insurance Committee of ICAI in bringing this revised Course material. I hope that the
members at large will make use of this material to the maximum possible extent for their
knowledge enrichment and in the overall interest of all stakeholders.

CA. Prafulla P. Chhajed

President, ICAI
PREFACE
Insurance, worldwide, is one of the most potent financial sectors. As per the published
data, the global direct insurance premiums surpassed the USD 5 trillion mark reaching
USD 5193 billion (6.1% of global GDP) in 2018 and it is expected to grow by 12-15 per
cent annually for the next three to five years. This growth means more scope and a larger
role for Chartered Accountants in the development and success of the industry.
It is our sincere belief that to enable the members of the Institute to play an appreciable
level of role in the insurance and pension sectors, they need to be provided with a general
framework for thinking about the effects of risk and a broad knowledge of risk
management and insurance. They need to be aware of the many public policy issues
related to risk, including legal liability and economic security issues apart from strong
conceptual foundation for understanding institutional details.
I wish to take the pleasant privilege of presenting before the members of the Institute the
revised study materials for Post Qualification Course on Diploma in Insurance and Risk
Management (DIRM). The study materials have been brought out in such a way that not
only members of the Institute pursuing the DIRM Course but also other stakeholders
would find it useful to acquire strong technical foundation in the areas of insurance and
risk management.
I wish to express my gratitude to CA. Prafulla P. Chhajed, President and CA. Atul Kumar
Gupta, Vice President, ICAI for their constant motivation to enable the Committee to move
forward on its various endeavours. I wish to place on record my sincere thanks to the
members and special invites of the Committee for their guidance and involvement in
bringing out this publication. We are grateful to Dr. V. Padmavathi, Associate Professor,
IFHE University, IBS – Hyderabad and Dr. V. Jayalakshmi, Associate Professor, Siva
Sivani Institute of Management, Hyderabad for writing this publication.
It is my sincere hope that the members of the Institute would find the contents of the book
professionally enriching. With humility I invite your constructive comments to further
improve the contents of the book.
CA. Charanjot Singh Nanda CA. Dhiraj Khandelwal
Vice Chairman, BFSIC Chairman, BFSIC
Date: 5th February 2020
CONTENTS
Foreword
Preface
Part A : RISK MANAGEMENT
CHAPTER-1 Introduction to Risk 3
CHAPTER-2 Introduction and Process of Risk Management 33
CHAPTER-3 Decision Making Under Conditions of Uncertainty 99
CHAPTER-4 Corporate and Enterprise Risk Management 126
CHAPTER-5 Risk Based Capital and Road to Solvency–II 152
CHAPTER-6 Corporate Governance 182
Part B: REINSURANCE
CHAPTER-1 Introduction to Reinsurance 223
CHAPTER-2 Reinsurance Regulations and Law in India 306
CHAPTER-3 Reinsurance Market 353
CHAPTER-4 Reinsurance Practice 397
CHAPTER-5 Reinsurance Accounting and Financials 443
APPENDIX 491
 Part A

RISK MANAGEMENT
 CHAPTER – 1
INTRODUCTION TO RISK
OUTLINE OF THE CHAPTER
1. Introduction
2. Risk and Uncertainty: Distinction
3. Risk, Peril, Hazard
4. Classification of Risk
5. Types of Risks
6. Sources of Risk

 LEARNING OBJECTIVES
After reading this chapter you should be able to
• Distinguish between Risk and uncertainty
• Understand the distinction between risk, peril and hazard
• Come to grips with various types of classifications of risk to which individuals /
organizations are exposed

Introduction
There is no generally or universally accepted definition of risk. It connotes different things
for different people. Some people use the term risk for insured items “this building is a
RISK MANAGEMENT AND REINSURANCE

poor risk”, some others to the chance of loss (the risk of loss in this venture or investment
is high) and yet others to the cause of loss (insurance is available against the risk of
burglary or risk of fire). Further, for economists and statisticians risk is associated with
variability (like variability of return on investment in an equity share of a corporation). Risk
is defined as variation in the range of possible outcomes. The greater the potential
variation, the greater the risk. Bernstein observes: “when we take a risk, we are betting on
an outcome that will result from a decision we have made, though we do not know for
certain what the outcome will be”.
People seek security. A sense of security may be the next basic goal after food, clothing,
and shelter. An individual with economic security is fairly certain that he can satisfy his
needs (food, shelter, medical care, and so on) in the present and in the future. Economic
risk (which we will refer to simply as risk) is the possibility of losing economic security.
Most economic risk derives from variation from the expected outcome.
One measure of risk, used in this study note, is the standard deviation of the possible
outcomes. As an example, consider the cost of a car accident for two different cars, a
Porsche and a Toyota. In the event of an accident the expected value of repairs for both
cars is 2500. However, the standard deviation for the Porsche is 1000 and the standard
deviation for the Toyota is 400. If the cost of repairs is normally distributed, then the
probability that the repairs will cost more than 3000 is 31% for the Porsche but only 11%
for the Toyota.
Modern society provides many examples of risk. A homeowner faces a large potential for
variation associated with the possibility of economic loss caused by a house fire. A driver
faces a potential economic loss if his car is damaged. A larger possible economic risk
exists with respect to potential damages a driver might have to pay if he injures a third
party in a car accident for which he is responsible.
Historically, economic risk was managed through informal agreements within a defined
community. If someone's barn burned down and a herd of milking cows was destroyed, the
community would pitch in to rebuild the barn and to provide the farmer with enough cows
to replenish the milking stock. This cooperative (pooling) concept became formalized in
the insurance industry. Under a formal, insurance arrangement, each insurance policy
purchaser (policyholder) still implicitly pools his risk with all other policyholders. However,
it is no longer necessary for any individual policyholder to know or have any direct
connection with any other policyholder.

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 INTRODUCTION TO RISK

Risk is a condition where there is a possibility of an adverse deviation from a desired

outcome that is expected or hoped for. There is no requirement that the possibility should
be measurable but only that it must exist.

Risk and Uncertainty

We often find the terms “risk” and “uncertainty” used interchangeably. However, a
distinction needs to be drawn between the two. Risk is the chance or probability, whether
high or low, that someone will be harmed by a hazard. Risk is often thought of in terms of
chance (or probability) of loss. Uncertainty falls into two broad categories. There are those
for which the probability of occurrence is calculable either on a priori
grounds or through the statistical analysis of a series of similar events that have occurred
in the past. The remainder does not lend them to such measurement either because their
occurrence follows no discernable pattern or because they are unique events. Professor
Frank Night called the first group risks, whereas the latter he described as uncertainties, in
his book Risk, Uncertainty and Profit. John Maynard Keynes a well known economist
considers that the element of surprise is an important element of a situation of uncertainty.
The importance of uncertainty arises from its influence on the process of decision-making
of individuals, businesses as also society.
While risk is a state of nature, uncertainty is a state of human mind. It is therefore
possible to consider a situation risky if a number of outcomes is possible and the actual
outcome that materializes is not known in advance. Thus, risk is defined as the relative
variation of the actual outcome from the anticipated or expected outcome. For instance,
for a manufacturing firm, the development of a new product is risky as the profits from the
sale of the product in the market are uncertain before the actual sale. Likewise, the
development of a new drug by a pharmaceutical company is characterized by risk because
of the range of possible outcomes with regard to the market reception for the drug.

Risk – Peril - Hazard

The concept of risk is to be distinguished from the terms ‘peril’ and ‘hazard’. ‘Peril’ is the
force that leads to a loss situation or ‘Peril’ is simply defined as the cause of loss e.g. Fire,
Burglary, Theft etc. (i.e. the force which lead to loss).
As per the insurance policy condition there may be three types of perils like:

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RISK MANAGEMENT AND REINSURANCE

1. Insured perils – which are covered under the basic policy – say, fire, riot, strike,
flood, inundation, etc. as covered in basic Fire Policy.
2. Extended Perils – which are covered with a little bit of extra premium along with the
basic cover. In Fire Insurance these are known as Add-on Covers but in other line of
business – say, Engineering or Motor Policies these extended perils are known as
extensions of the basic cover.
3. Perils not covered at all – those may be either the uninsured perils or the excluded
perils (as excluded specifically by inserting the printed conditions) specifically
stipulated in the policy copy itself.
Again as per the ‘origin’ of a loss is concerned, the perils may be divided into three types
as below:
1. Act of God Perils – Those are natural catastrophe or calamity –like flood, inundation,
storm, earthquake, landslide, rock slide, etc.
2. Process related Perils – These are the perils associated with the starting of the
operation of any plant / machine or any instrument being put to work – say whenever
we put any machine say a generator or transformer for electricity supply it may be
subjected to breakdown, overloading or short-circuit, etc. – all such perils are known
as operational perils.
3. Human related perils – These are absolutely related to Human being. Some of the
perils are absolutely organized by bad people- like theft, burglary, dacoity, riot/strike
& malicious damage. Even Terrorism damage covered by insurers is the gifts of
terrorists (a group of people.
Perils that cause damage to property may include theft, burglary, fire, hailstorm,
windstorm, lightning and earthquakes. An example of peril is: if Rama’s car is
damaged in a collision with Ramesh’s car, collision is the peril or cause of loss.
A Hazard is a pre-set condition – that may create or increase the chance of loss arising
from a given peril or under a given condition. Hazard means the potential to cause injury
or illness and can apply to substances, methods or machines. Three major types of
hazards are usually distinguished.
(a) Physical hazard

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 INTRODUCTION TO RISK

(b) Moral hazard and

(c) Morale hazard
Physical hazard: A physical condition that heightens the chance of loss is called physical
hazard. A large number of examples of physical hazard from our daily life can be cited,
such as defective electrical wiring in a cinema hall which increases the chance of fire, bad
and poorly maintained roads that increase the chance of motor accidents and defective
locking system on the main door of an apartment that increases the chance of theft. It is
any hazard arising from the Material, Structural, or Operational failures of the risk itself
apart from the persons owning or managing it.
Moral Hazard: Moral hazard is a condition characterized by defects in the character of an
individual such as dishonesty that increases the frequency of loss or severity of loss or
both. Moral hazard is a common occurrence in insurance and is not easy to control.
Examples: making a fraudulent insurance claim, submitting an insurance claim for an
inflated amount and setting fire to an insured godown stocked with inventory.
It is arising out of the fraudulent activities of either insured or insurers. It involves any
tendency for the presence of insurance to increase the probability of loss or its amount. An
extreme example would be an individual who previously burned his own property to collect
the insurance claim. Insurance may affect behaviour in that less effort is taken to avoid the
loss, or the costs of the loss are exaggerated. More examples may be incurred by an
insured person than incurred by the same individual without insurance. All are the example
of Moral hazards. Losses become larger for the insurer due to the existence of Moral
hazard. With a view to controlling moral hazard, insurers take a number of steps such as
careful underwriting practices, and by including a number of provisions in the insurance
policy such as exclusions, deductibles and riders. Moral hazard minimization is possible
only through the following methods (which are not available in Traditional Risk
Management process but these are the part of Enterprise Risk Management processes):
1. Loss experience rating.
2. Partial risk sharing.
3. Credits for loss control.
4. Claims investigation.
5. Criminal prosecution.

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RISK MANAGEMENT AND REINSURANCE

Morale Hazard: It relates the condition or situation as existing in the society. It is very
prominent & highly existent in Health Insurance- say, a person has three daughters named
Ganga, Jomuna, Swaraswati and he has taken medical / health insurance cover under his
Mediclaims policy only for his first two daughters and unluckily Swaraswati suffered an
accidental injury – so the person will admit his third daughter in the name of Ganga or
Jomuna – i.e. he will go for this kind of morale hazard. Again whenever a patient is taken
to a hospital – the first thing the hospital authority will ask is the details about a Medical
/Mediclaim policy hold by the person to be treated under that authority. If the sum insured
of the policy is found as Rs. 5 Lacs, he will be immediately admitted to ICU but if the sum
insured is seen as by the hospital authority as Rs. 50, 000/- the patient may be treated at
the corridor of the hospital.
Sometimes, a distinction is drawn between moral hazard and morale hazard. While, as
defined earlier, moral hazard refers to a deliberate dishonesty resulting in increasing the
frequency or severity of loss, morale hazard refers to carelessness or indifference to loss
because of the presence of insurance. Examples include leaving the main door of a house
open to make entry of a burglar easy, leaving car keys in an unlocked car door, and
carelessness in regard to maintenance of health because of existence of a health
insurance policy. Such careless acts increase the chance of loss.
Inception Hazards – That give rise to the loss incidents– which starts or originates the
loss incident like the perils of fire, explosion or collapse, etc. arising out of say,
Inception hazards Proximate cause / peril operated
Loose wiring Fire
Smoking Fire
Friction Fire
Overheating Fire / Explosion
Hot surfaces Fire
Welding Fire
Sparks (electrical / mechanical) Fire
Chemical action Fire / Explosion

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 INTRODUCTION TO RISK

Static electricity Fire

Lightning Fire / Collapse
Burner flames (boiler / oven / drier) Fire

Contributory Hazards – Those contribute to spread the loss like burning f a building may
take a disastrous situation if fire is subsequently passes on to the neighbouring building /
house due to –
1. Poor construction of buildings (inferior material/wood/timber/plastic skylights/ glass
facades);
2. False ceiling/internal partitions/wooden lining;
3. Located in a difficult terrain/crowded place;
4. High density fire load (Solvents/ Chemicals);
5. Ducts for air conditioning, dust, vapour;
6. Bad housekeeping, dry grass, congested layout;
7. Unattended area;
8. Absence of safety devices – like fire fighting equipment;
9. No fencing, no security arrangements, no lighting;
10. No proper waste disposal method;
11. No work permit system;
12. Possibility of riot, strike or vandalism, etc..
Special Hazards – Those which are giving raise hazardous situations –some are given as
below:
1. Bulk storages (coal in open, solvent tanks, LPG tanks);
2. Complex chemical processes (Refinery/ Fertilizer/ Solvent Extraction Units);
3. Spray painting operations;
4. Pulverizing operations;

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RISK MANAGEMENT AND REINSURANCE

5. Material susceptible to Spontaneous combustions;

6. Pollution and contamination risks, etc.
Political Hazards – Those which arise mainly from political risk i.e. connected to political
connections like that are mentioned below:
1. Terrorism;
2. War;
3. Rebellion, Mutiny;
4. Military coupe;
5. Confiscation;
6. Abandonment/ Government ban, etc.
Natural Hazards – The risks i.e. subject matters of insurance if exposed to the following
natural calamity like:
1. Flood, Storm, Cyclone, Hurricane, Inundation;
2. Earthquake, Volcanic eruptions;
3. Snow/ Frost/ Ice storms;
4. Landslides/ Rock slides;
5. Subsidence;
6. Forest fire/ Bush fire, etc.
Characteristics of An Insurable Risk
We have stated previously that individuals see the purchase of insurance as economically
advantageous. The insurer will agree to the arrangement if the risks can be pooled, but
will need some safeguards. With these principles in mind, what makes a risk insurable?
What kinds of risk would an insurer be willing to insure?
The potential loss must be significant and important enough that substituting a known
insurance premium for an unknown economic outcome (given no insurance) is desirable.

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 INTRODUCTION TO RISK

The loss and its economic value must be well-defined and out of the policyholder's control.
The policyholder should not be allowed to cause or encourage a loss that will lead to a
benefit or claim payment. After the loss occurs, the policyholder should not be able to
unfairly adjust the value of the loss (for example, by lying) in order to increase the amount
of the benefit or claim payment.
Covered losses should be reasonably independent. The fact is that one policyholder
experiences a loss should not have a major effect on whether other policyholders do. For
example, an insurer would not insure all the stores in one area against fire, because a fire
in one store could spread to the others, resulting in many large claim payments to be
made by the insurer.
These criteria, if fully satisfied, mean that the risk is insurable. The fact that a potential
loss does not fully satisfy the criteria does not necessarily mean that insurance will not be
issued, but some special care or additional risk sharing with other insurers may be
necessary.
Risk means the probability and consequences of occurrence of injury or illness. Risk will
depend on such factors as the nature of the hazard, the degree of exposure and individual
characteristics.

Classification of Risks
Risks are basically classified into four categories.
1. Pure Risk and Speculative Risks
2. Dynamic and Static Risks
3. Fundamental and Particular Risks
4. Subjective and Objective Risks

1. Pure Risk and Speculative Risks

A traditional classification of risk distinguishes between pure risk and speculative risk.
Pure risk exists when a situation is characterized by uncertainty as to whether or not loss
will occur. Pure risk does not admit the possibility of gain but only potentiality for loss or
status quo. Examples of pure risk include prospect of untimely and premature death, likely
damage to property by flood, earthquake, lightning and fire and catastrophic medical

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RISK MANAGEMENT AND REINSURANCE

expenses. Speculative risk is present when an event can result in either a gain or a loss or
status quo. Examples of situations involving speculative risk include individual’s decisions
to buy shares or investment decisions of business firms or business ventures and
investing in real estate.
Three prime reasons warrant the distinction to be drawn between pure and speculative
risks. While insurance companies basically insure pure risks, speculative risks are
generally not considered insurable, barring a few exceptions like institutional portfolio
investments. Speculative risks are voluntarily accepted because of its two-dimensional
nature in that they offer the possibility of gain.
Second, while the law of large numbers can be easily applied to pure risks, speculative
risks are not easily amenable to the application of law of large numbers which facilitates
prediction of future loss experience by insurance companies. A notable exception is the
efficient manner in which casino operators apply the law of large numbers to the
speculative risk of gambling.
Third, while the society is harmed by the presence of pure risk when a loss occurs, society
may benefit despite the occurrence of loss from a speculative risk. There is no doubt that
the society does not benefit from the loss arising from a pure risk situation. A company
developing a new technology to produce computers at a lower cost may benefit the society
as a whole while some existing computer companies may become bankrupt because of
this development, is an example in this regard.
However, it is possible that in some situations both pure and speculative risks may exist.
Likewise, some of the speculative risk decisions which are motivated by earning profit
might have an impact on pure risk exposures. For example, developing and introducing a
new product into the market by a manufacturing firm mainly entails speculative risk. In
addition, the decision might also lead to a pure risk exposure such as potential product
liability.
Another important point is to be noted. Not all pure risks are insurable. Therefore
sometimes a further distinction is drawn between insurable pure risks and uninsurable
pure risks. Insurable pure risks that individuals or business firms are exposed to can be
classified as follows:
(a) Personal Risks,

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 INTRODUCTION TO RISK

(b) Property Risks,

(c) Liability Risks, and
(d) Risks arising from the failure of others
(a) Personal Risks: Personal Risks consist of the possibility of loss of income or assets
as a consequence of a person’s loss of earning power. In general, the loss of theability to
earn income by a person is subject to four perils. (i) Premature death (ii) dependent old
age, (iii) sickness or disability, and (iv) unemployment.
(b) Property Risks: Anyone owning property faces property risks as it can be destroyed
or stolen. There are two types of losses relating to property risks. Direct loss or indirect
loss or consequential loss. An example of a direct loss relating to property is the loss
occasioned by a building destroyed by fire. The owner of the building suffers loss to the
extent of the value of the building. However, the owner of the building, besides losing the
value of the building, loses the use of the building during the period of reconstruction. This
is an instance of the indirect or consequential loss to the property. Thus the owner of the
building may face property risks, involving two types of losses:
(i) loss of the property itself, and
(ii) loss of the use of the property resulting in lost income or additional expenses.
Property Risks may be the direct losses or the consequential losses arising out of such
specific direct losses being covered under the affected insurance policy. These risks,
which are not individual in nature, can also be called pure risks arising from –
(i) The loss of the property
(ii) Loss of use of the property and
(iii) Additional expenses occasioned by the loss of the property.
(c) Liability Risks: Generally, the essence of the liability risk is the unintentional injury
of other persons or unintentional damage to their property through negligence or
carelessness. Liability may also result from deliberately intentional injuries or damage.
Laws stipulate that a person causing injury to another or causing damage to another’s
property is held responsible for the harm or damage caused. In addition, an employer or
other principal is responsible for the acts of omission or commission of agents or
employees and can be held vicariously liable for their negligence. Thus, liability risks

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involve the possibility of loss of present assets or future income as a consequence of

damages estimated or legal liability arising out of either intentional or unintentional acts or
the invasion of other’s rights.
Here the liability means ‘responsibility’ i.e. being responsible for –
(1) ‘Act of self’ or (2) ‘On behalf of those whose act, he/she is responsible’.
(d) Risks arising from others’ failures: A person’s failure to perform a service agreed
upon or his/her failure to meet an obligation which he/she undertakes to discharge and as
a consequence another person incurs a financial loss, there exists a risk. Examples of
such risks include a contractor’s failure to complete a building in time as per schedule or a
debtor’s failure to make payments as agreed upon.
Losses cover in insurance (as well as in Risk Management Processes) are given below:
• Property Damage
1. Buildings,
2. Plant & Machinery,
3. Furniture /Fixtures/Fittings,
4. Stock in process/open/ godown/ in transit,
5. Electrical installations/equipment/ancillaries,
6. Motor vehicles, etc.
• Liability
1. Public liability as per the statutory law (PLI Act, Third party liability, etc.).
2. Product liability as per common law, contractual liabilities (as per various
contractual obligations towards the customers, principals, other sub-
contractors, etc. as per Consumer Protection Act).
3. Professional liability in course of doing professional jobs.
4. Legal liabilities of the employers towards their employees.
5. Legal liability arising out of falling from height, breakdown & other malfunction
of Lift used for elevating the people or materials against the owner of the lift /
building (where it is installed).

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 INTRODUCTION TO RISK

6. Commercial Global Liabilities of the Logistic Companies (engaged for the

transit of various items).
7. Liabilities for Clinical Trials for the various medicines (manufactured by drug
manufacturers) before introduction of that drug in the market for public use.
8. Any other kinds of legal liabilities existing as the possibility may be faced by
any individuals, etc.
• Human -Life
1. Loss of life while engaged in professional duty,
2. Accidental death,
3. Bodily injury,
4. Collision with vehicle, etc.

2. Dynamic and Static Risks

Another classification of risk, cutting across pure and speculative categories, is the
division into static risks and dynamic risks. Dynamic risks arise from changes that take
place in every society; that is, economic, social, technological, environmental, and political
changes. Static risks are those that would exist in the absence of such changes.
Dynamic risks are closely related to the speculative risks whereas most pure risks are
examples of static risks.

3. Fundamental and Particular Risks

Fundamental risks are those which affect the whole of society or a major part thereof or
some groups, such as uncertainties arising out of the economic or political system or
natural catastrophes such as earthquakes and floods. They are impersonal in both cause
and effect. Particular risks on the other hand affect mainly the individual or firm and arise
from factors over which he or it may exert some control. This distinction assumes
importance as social insurance and government insurance programmes or government
subsidies may be necessary to deal with situations of fundamental risk. A particular risk is
a risk that does not affect the entire community or groups of persons within the economy
but affects only individuals. The individual deals with particular risks through the use of
insurance, loss prevention or some other technique of risk management.

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RISK MANAGEMENT AND REINSURANCE

Examples such as bank robberies and car thefts affect the particular individuals or firms
experiencing such losses. In contrast, a fundamental risk is a risk that affects a group of
persons, or the entire economy. Risks such as natural disasters, war, high inflation and
cyclical unemployment are some of the examples of fundamental risk. The recent Gujarat
earthquake is another example of fundamental risk.

4. Subjective and Objective Risks

A fourth classification of risk that we come across is dependent upon the criterion whether
it is based upon the state of mind of an individual or it is precisely observable -subjective
or objective risk. If the type of risk is more precisely observable and therefore measurable
it is referred to as objective risk. In this type of risk, the actual experience may differ from
the one expected. On the other hand, subjective risk basically emanates from a person’s
state of mind or mental attitude. As a particular individual’s perception of risk in a
particular situation may be different from another, there is a possibility of making different
decisions by two individuals in a situation that is seemingly identical. It is clear, therefore,
that it is not sufficient to know the degree of objective risk. We have to also learn the
attitude towards risk of a person who is acting on the basis of this knowledge.
Individuals, businesses and societies are increasingly subject to risk and have to cope
with it. Bhopal and Chernobyl, the Tsunami tragedy) illustrate how a single event may
impose serious harm on societies. The management of risk has become considerably
more complex and more important today than in the past. In most cases, our concern
about risk relates ultimately and exclusively to individuals, whether as members of
families, as owners, employees, or customers of businesses or as citizens.

Types of Risks
1. Actuarial risk
2. Asset risk
3. Pricing risk
4. Interest rate risk
5. Systematic risk
6. Liquidity risk

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 INTRODUCTION TO RISK

7. Operational risk
8. Legal risk
9. Credit risk

Actuarial risks
A contract of insurance, though basically meant for financial protection also offers several
other benefits to policyholders. For example, a life insurance policy may cover death,
incapacity/disability or injury but it may contain certain clauses and promises for loan,
surrender or other benefits.
All the promises and options are embedded in the insurance contract but is the insurer
charging enough premium to fulfill all their promises? This is actuarial risk. It is the risk of
charging too little premium and suffering lower cash flows, which is insufficient to fulfill
promises. Actuarial risk may arise from the following factors:
I. Risk from incorrect mortality or morbidity structured in the pricing. The actual
experience may be different from those built into the pricing of products. The
deviation may arise due to inexperience in assessing the loss or the loss projections
exceeding even in the conduct of normal business, which again depends on the
nature of risks insured.
II. Risk from loans and surrender options. Contracts of insurance provide several such
options to policyholders. Cash values are guaranteed in such options and these
promises are embedded in the contract features. These additional facilities and
options are important from the point of view of marketing the insurance products,
offer convenience to customers and also fulfill regulatory requirements.
Policyholders with such options of loan and surrender can demand cash value at any point
of time. These payments are made at book value. Risk arises when the market value of
assets that supports these payments is less than the book value, creating liquidity
problems. The timing of such withdrawal sometimes would complicate the situation, e.g.,
when the interest rate rises it results in decrease in market value.
Options of loan and surrender are more valuable to policyholders during rising interest
rates, yielding better returns for them than insurance policies.

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Asset risks
Assets of insurance companies consist of investments made by them. In due course of
managing the investment portfolio, assets are prone to risks, which may alter their value
as well as the returns generated from them.
The business of insurance companies is to provide risk coverage to the policyholders.
Premium is collected from the policyholders to provide risk coverage. The corpus or fund
so collected and accumulated is maintained as reserve liability for servicing the
policyholders.
Since the insurance companies promise to provide assured returns to policyholders in
respect of certain policies and satisfy the claims arising out of policies, the funds have to
be invested or lent out as loans and these investments/deployments form the assets of an
insurer. These assets have to generate adequate returns and supplement the regular
profits from insurance related operations.
Insurance company assets (investments and deployments as loans) are exposed to risks,
i.e.,
• Uncertainty with regard to safety of the invested funds
• Possible decrease in value of the assets due to unfavourable market movements
which may in turn adversely affect the generation of expected returns
• Possible default in the payment of interest and the principal by the borrower.
Asset risk arises when insurance companies are unable to meet claims of policyholders in
full or in time due to poor quality of its assets.
With gradual deregulation of the investment portfolio of the insurance companies, a higher
percentage of assets are at the disposal of insurers for investments in market instruments.
Even the type of instruments and investment avenues are growing in number. Hence the
risk management function is growing in importance in the insurance sector.
An effective strategy is therefore required to manage the assets and the liabilities of the
insurance companies. The majority of the assets of the insurance companies lie in gilts,
debt instruments, and equity instruments, which are susceptible to risk from adverse
market movements.
Since the insurers assure the safety of funds and the stability of returns, they have to
invest their asset portfolio in proper avenues bearing in mind these goals.

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If this aspect of financial management is not handled properly the insurer may not be able
to meet his commitments to the policyholders and servicing their claims may become
difficult. The returns may fall and so also the value of investments.

Pricing risk
The price of a product should be adequate to pay for losses, fetch profits and balance the
risk and return profile, i.e., if the risk from a type of policy is higher, then the return should
also be correspondingly higher by appropriate fixing of premium. The product should be
competitive in the market with respect to its price, otherwise the insurer will lose market
share.
In addition, price should leave a profit margin after meeting the cost and servicing
expenses. If the margin is strained the returns are prone to be affected.
There is also a risk of the level of costs being maintained in future. If the costs of providing
insurance increase then the profit margins are strained.
Pricing risk would arise due to increase in value of liability due to inappropriate pricing that
would reduce the future cash inflows. There can be many reasons for decrease in cash
flows including that the mortality and morbidity rates are higher than anticipated, income
and return from investment are lower than expected.
Managing risk is difficult as information related to liabilities is not freely available
compared to assets.
All risks must be properly anticipated, assessed and quantified. A risk premium is added to
the price to set off or compensate for this and ensure a safe profit margin. Also, any
probable future change has to be taken into account and the company should be geared
up to handle this.

Interest rate risk

The changes in market interest rates can adversely affect an insurance company’s
financial condition. It affects value of both assets and liabilities of the insurer. There is a
risk of insolvency if the fluctuating interest rates affect assets more than liabilities.
Fluctuations in value of assets and liabilities have to be judged based on whether interest
rate increases or decreases.

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When interest rate increases the value of both assets and liabilities would decrease. Risk
arises when this decrease in value is more in liabilities than in assets resulting in reduced
capital.
When interest rate increases, there will be more surrender of policies and increase in
loans due to which the companies have to sell assets. In an already depressed market
such sales will fetch less value forcing more sale of assets.
When interest rate decreases, the value of both assets and liabilities will increase. The
risk arises when the value of liabilities increases more than the assets.
Policyholders will add more funds forcing the company to add assets purchasing them at
its value.
However such interest rate risk would be managed using classic management concepts
like duration, convexity, etc.
Interest rate risks can be of the following types:
Rate level risk - if the interest rates change (as administered by RBI), the income from
interest on invested securities also changes.
Volatility risk - The interest rates may also change due to fluctuations in market demand.
This may reduce the interest income from investments.
Price risk - There remains a threat that the value of a security may decrease if the interest
rates rise and vice versa.
Reinvestment risk - It may happen that if the interest rates go down, the interest income
received from previously made investments cannot be invested again at the same rate at
which the principal was originally invested. They have to be invested at a lower rate of
interest.
Inflation risk - If the changes in interest rates do not keep pace with the change in the rate
of inflation then the real rate of interest (the real income obtained after accounting for
charges for expenses and inflation) may be negative.
Distress sale - Investors may withdraw funds in times of adverse rate movements and this
in turn reduces the market value of funds.

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Systematic risks
There are many economic factors that affect value of financial assets and liabilities.
Systematic risks cannot be eliminated totally but can be managed by hedging.
Interest rate is one major factor contributing to systematic risks, others are inflation,
foreign exchange, etc. because of variation in interest rates the values of assets and
liabilities vary as explained earlier. Interest rate also causes refinancing risk and
reinvestment risk.
Refinancing risk is the risk of cost of rolling over of an investment every year exceeding
the benefits. Reinvestment risk is the return from new assets being less than cost of
financing.

Liquidity risk
To service the claims of the policyholders the insurance companies need to have cash or
near cash (readily marketable) instruments. Lack of adequate liquidity may lead to
bankruptcy of the insurer if the amount of claims exceeds the amount of available funds.
Liquidity crisis may arise due to unforeseen large claims or loan surrenders from
policyholders during interest rate increase.
Liquidity risk management is about measuring and managing the liquidity needs, i.e., meet
any liability payments to the policyholders and avoid any adverse situations. The
maturities of the instruments invested and the assets should correspond to the liabilities
both with respect to the amount and timing of payout. The inflows of funds and the payouts
should be properly estimated for determining the amount of liquidity to be maintained. The
need for adequate liquid funds to service the claims is thus obvious.
It should be kept in mind that excess liquidity might reduce the profits as maintaining idle
cash deprives the insurer from profitably deploying the funds in investible instruments.
The invested assets should be diversified by investing in different types of instruments
belonging to different sectors and companies.
Besides, the required percentage of instruments should be readily marketable and at the
desired price, i.e., the instrument should be capable of being easily offloaded in the market
and at a price not less than its intrinsic value to ensure availability of liquid funds to
service the claims.

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If this aspect is overlooked, then such sticky investments may cause bottlenecks in
realising the values at the required time when demand for funds arise.
It should be noted that liquidity should be maintained vis-à-vis profitability though the two
may be inconsistent. For example long term securities generate higher profits but offer a
lower degree of liquidity while the short term securities offer higher liquidity but low
returns. Thus a proper balance depending on the asset liability portfolio has to be
maintained by the company.
Besides idle cash imparts liquidity but there is a cost associated with it in the form of
opportunity cost. Opportunity cost is the interest income lost on idle cash.

Operational risk
An insurance company faces risk from its own operations if the systemin placeis not
geared to handle the required challenges arising in due course of business. Operational
risk is the risk of loss resulting from inadequate systems and control, human error or
management failure.
The inefficiency may be in the process implemented, the business model adopted,
compliance to certain rules and practices, fraud committed by insiders or outsiders,
technology upgraded etc. Nowadays information technology systems and solutions failure
is an impediment to the normal functioning of the company.
The operational or procedural aspects should be efficient to meet any unanticipated
threats in future. Business practices always run the risk of becoming obsolete or being not
adequate to match any unanticipated or peculiar situation. They also need to comply with
legislation and regulations. The ability of management, decision-making abilities should be
upto the mark to face any unforeseen situations and allow the developments to take place
while keeping it under controllable limits.
The companies also face threat from external risks like properly gauging the current
market trends and altering the business strategies suitably. If the company is not geared
up for this, the market share may be eroded causing loss in revenues.

Legal risk
Legal risks are threats to an insurance company due to the technical intricacies of the law.

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Legal risks may erupt from the following sources:

• In the implementation of individual contracts
• By a change in the legislation and regulations brought about by the government
• Any new verdicts given by the courts
An insurance company executes legal contracts to provide assurances. These are subject
to certain legal terms and conditions, which may be unique to a particular policy. These
commitments have to be adhered to by the company. Such terms and conditions may be
subject to changes over time or certain peculiar situations may develop for which no
stipulations would have been made at the time of selling the policy. These loopholes may
pose a threat to the insurance company and may cause unanticipated increase in
liabilities.
An insurance company faces risk from the change in regulations by the government. For
example, if a particular line of