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Unit 1 of 4 · M.Com Sem 4

Unit 1: Risk concepts and demand for insurance

Risk Management in Insurance Business notes · PTU syllabus (MCOPBI422-18)

3 min read8 topics10 exam questions
On this page
  1. Unit summary
  2. Concept of risk
  3. Types of risk
  4. Corporate and personal risk management process
  5. Risk identification and measurement
  6. Pooling and diversification
  7. Risk aversion and the demand for insurance
  8. Insurability of risk
  9. Loss control, risk retention and reduction decisions
  10. Key terms
  11. Quick revision
  12. Important questions

Unit summary

Why do people and firms buy insurance, and which risks can be insured? This unit covers the concept and types of risk, corporate and personal risk management, risk identification and measurement, pooling and diversification, risk aversion and the demand for insurance by individuals and corporations, insurability of risk, and decisions on loss control, risk retention and reduction.

After this unit you can

  • Explain the concept and types of risk and the risk management process
  • Explain pooling and diversification as the basis of insurance
  • Explain risk aversion and the demand for insurance by individuals and firms
  • Explain insurability and decisions on loss control, retention and reduction

PTU syllabus topics

  • Concept of risk
  • corporate and personal risk management
  • types of risk
  • risk identification and measurement
  • pooling and diversification
  • risk aversion and demand for insurance by individuals and corporations
  • insurability of risk
  • loss control
  • risk retention and reduction decisions
FrameworkRisk treatment matrix

  • Retain

    Low frequency, low severity

  • Reduce

    High frequency, low severity: loss control

  • Transfer

    Low frequency, high severity: insure

  • Avoid

    High frequency, high severity

1

Topic 1

Concept of risk

  • Risk: the possibility of an adverse deviation from a desired or expected outcome; can be measured with probabilities.
  • Uncertainty: a state of doubt about the future where probabilities cannot be estimated (Frank Knight, 1921).
ComparisonRisk vs uncertainty
Risk
Uncertainty

Probability

Known or estimable

Unknown

Measurement

Objective, statistical

Subjective

Insurable

Yes (if conditions met)

No

Example

Probability of a house fire in a city

Impact of a future technology

  • Peril: cause of loss (fire, flood, theft). Hazard: condition that increases the chance or severity of loss — physical (faulty wiring), moral (dishonesty), morale (carelessness because insured), legal (court tendencies).
2

Topic 2

Types of risk

ClassificationTypes of risk
Risk

  • Pure vs speculative

    Loss or no loss (insurable) vs loss or gain (investment)

  • Fundamental vs particular

    Group-wide (earthquake, inflation) vs individual (car accident)

  • Static vs dynamic

    Not due to change (fire) vs due to change (new technology)

  • Personal risks

    Premature death, old age, illness, unemployment

  • Property risks

    Direct and indirect (consequential) loss

  • Liability risks

    Legal liability for injury or damage to others

  • Enterprise risks

    Strategic, operational, financial, compliance, reputational

  • Sources: physical environment, social environment, political, legal, economic, operational, cognitive (perception errors), technological (cyber).
3

Topic 3

Corporate and personal risk management process

ProcessRisk management process
  1. 1Identify loss exposures

    Property, liability, personnel, income

  2. 2Measure and analyse

    Frequency, severity, maximum possible loss

  3. 3Select techniques

    Avoid, control, retain, transfer

  4. 4Implement the programme

    Policies, insurance purchase, safety measures

  5. 5Monitor and review

    Changes in exposures and costs

  • Corporate risk management: risk manager, risk policy statement, Enterprise Risk Management (ERM) integrating all risks (COSO, ISO 31000); board-level risk management committee (mandatory for top 1,000 listed companies under SEBI LODR).
  • Personal risk management: identify risks to life, health, income, property and liability; use emergency funds, term and health insurance, motor and home insurance, wills.

Objectives

  • Pre-loss objectives: economy (lowest cost), reduce anxiety, meet legal obligations (third-party motor insurance, public liability).
  • Post-loss objectives: survival, continuity of operations, earnings stability, continued growth, social responsibility.
4

Topic 4

Risk identification and measurement

  • Identification: checklists, financial statement analysis, flow charts, inspections, contract review, loss histories (see risk perception tools in Unit 2).
Key formulasRisk measurement

  • Expected loss

    Σ (Probability × Loss)

  • Standard deviation of loss

    √ Σ p (L − E(L))²

  • Coefficient of variation

    σ ÷ Expected loss

  • Maximum probable loss

    Largest loss likely under normal conditions

  • Frequency and severity: the two dimensions used to prioritise risks.
5

Topic 5

Pooling and diversification

  • Pooling arrangement: individuals agree to share losses equally — each pays the average loss; the variance of average loss falls as the number of participants rises (law of large numbers), making losses predictable.
Key formulasEffect of pooling

  • Standard deviation of average loss

    σ ÷ √n (for n independent, identical exposures)

Example

Two people each face a 20% chance of a ₹2,500 loss (expected loss ₹500). Alone, SD = ₹1,000; pooling two reduces SD of each person's cost to about ₹707; with 100 participants it falls to ₹100.

  • Pooling works best when losses are independent (uncorrelated); correlated losses (earthquakes) limit diversification — handled by reinsurance and catastrophe bonds.
6

Topic 6

Risk aversion and the demand for insurance

  • Risk aversion: preferring a certain outcome to a gamble with the same expected value — diminishing marginal utility of wealth (concave utility function).
  • Individuals: buy insurance when the premium (expected loss + loading) is acceptable relative to the utility gained from certainty; demand rises with risk aversion, wealth at stake, and lower loadings; falls with high premiums and availability of other protection.
  • Corporations: shareholders can diversify, so firms buy insurance for other reasons — reduce costs of financial distress, lower tax costs (convex tax schedules), access insurers' loss-control and claims services, reduce agency costs, meet regulatory or contractual requirements (lenders, motor third party).

Exam tip

Distinguish "why individuals buy insurance" (risk aversion) from "why corporations buy insurance" (distress costs, taxes, services).

7

Topic 7

Insurability of risk

ProcessRequirements of an insurable risk
  1. 1

    Large number of exposure units

    Law of large numbers applies

  2. 2

    Accidental and unintentional loss

  3. 3

    Determinable and measurable loss

  4. 4

    No catastrophic loss to the pool

    Or reinsured

  5. 5

    Calculable chance of loss

  6. 6

    Economically feasible premium

  • Adverse selection: people with higher-than-average risk are more likely to buy insurance (e.g., those with health problems buying health cover). Control: underwriting, medical tests, waiting periods, exclusions, differential premiums, group insurance, mandatory cover.
  • Moral hazard (dishonesty after insurance) controlled by deductibles, co-payments and investigation.
8

Topic 8

Loss control, risk retention and reduction decisions

ClassificationMethods of handling risk
Risk handling

  • Avoidance

    Do not undertake the activity

  • Loss control

    Prevention (reduce frequency) and reduction (reduce severity)

  • Retention

    Bear the loss — active (planned, deductibles, self-insurance) or passive

  • Non-insurance transfer

    Contracts, hold-harmless clauses, hedging, outsourcing

  • Insurance

    Transfer to an insurer for a premium

  • Separation and diversification

    Spreading exposures

  • Degree of risk: the relative variation of actual losses from expected losses — measured by the objective risk formula and standard deviation.
Key formulasDegree of risk

  • Objective risk

    (Actual loss − Expected loss) ÷ Expected loss

  • Expected loss

    Probability of loss × Size of loss

  • Law of large numbers

    As exposures increase, actual loss experience approaches expected loss

Example

An insurer expects 1% of 10,000 houses (100) to burn. If 110 burn, objective risk = 10 ÷ 100 = 10%. With 1,00,000 houses, the relative variation falls — the basis of insurance pooling.

Key terms

Pooling
Sharing losses among many participants
Law of large numbers
Average loss becomes predictable as exposures increase
Risk aversion
Preference for certainty over a gamble of equal expected value
Insurable risk
Risk that meets conditions for efficient insurance
Loss control
Measures to reduce frequency or severity of losses

Quick revision

  • Risk types: pure/speculative, fundamental/particular, personal/property/liability.
  • Measurement: expected loss, SD, frequency and severity.
  • Pooling reduces SD of average loss by √n.
  • Individuals buy insurance due to risk aversion; firms due to distress costs, taxes, services.
  • Insurability conditions; avoid, reduce, retain, transfer.

Important exam questions

Practice questions written to the PTU exam pattern for this unit's syllabus: short answers (Section A style) and long answers (Sections B and C style).

Short-answer questions

  1. Q1.What is risk?
  2. Q2.What is a pooling arrangement?
  3. Q3.How does pooling reduce risk?
  4. Q4.Why are individuals risk-averse?
  5. Q5.Why do corporations buy insurance?
  6. Q6.State the requirements of an insurable risk.

Long-answer questions

  1. Q1.Explain the concept, types and measurement of risk.
  2. Q2.Explain pooling and diversification as the basis of insurance.
  3. Q3.Explain risk aversion and the demand for insurance by individuals and corporations.
  4. Q4.Explain insurability of risk and decisions on loss control, retention and reduction.

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