INSURANCE RISK MANAGEMENT

 INTRODUCTION

From time immemorial, man has sought ways of controlling risk to which individuals either private or grouped together as commercial and business ventures are exposed.

Until about 20 years ago, the concept of risk management was regarded as a subject and an arm of practical management. It is a multidisciplinary subject which brings together the ideas and techniques drawn from various disciplines, to provide sound conceptual functions and a set of tasks for the analysis and positive control of risks.

It was widely acclaimed that risk management was first introduced in the United States of America in the early fifties as a result of dissatisfaction on the part of the corporate and individual insurance buyers with the inadequate premium discount given by insurance underwriters to compensate for higher risk retention and the loss prevention methods being adopted for their insured risks.

The Concept of Risk in Insurance (Conditions of Certainty, Conditions of Risk and Conditions of Uncertainty)

These conditions relate basically to the state of an investor’s knowledge about underlying factors which affect the outcome of his investment decisions. The nature and effects of each condition on investment activities will now be discussed.

Conditions of certainty can be said to prevail where a potential investor has full knowledge of the ultimate outcome of an investment opportunity. This implies:

1.  Perfect knowledge, from the outset, of the exact nature and timing of the stream or cash-flow to be expected from an investment opportunity. 
2. The expectation that the anticipated outcome would not be subject to chance. 

Given that situation, an investor would conceptually have a single- valued expectation of the outcome of an investment opportunity. Since such an outcome would not be subject to chance, benefits expected from the investment ex-ante would synchronize with benefits actually realized ex-post.

Situations of single-valued expectations are rare in the investment world. In practice, one can speak of certainty conditions whenever the number of possible outcomes from an investment activity falls within a very narrow range of possible values. In that case, there would be only a very remote possibility of divergence between expected and realized investment outcomes. Investments in fixed income financial assets can be so categorized, especially where the likelihood of default in the payment of interest or principal is remote.

An investor in government treasury securities can, for instance, calculate with fear. Uncertainty has been described as one of the fundamental facts of life. Many individuals and business enterprises fail to realize the magnitude of risks to which they are exposed every minute of the day. How many people for instance, are aware that the building in which they are can catch fire from many sources anytime and so place them in the danger of being injured or possibly losing some of their property, such as documents? Equally, individuals face the risk of imminent death from numerous causes both known and unknown. Just remember the case of Dele Giwa, a renowned Nigerian journalist who was killed at his breakfast table by a letter bomb on the 19th of October, 1986. When he received the parcel, little did he know he would be gone forever the next minute. That was the risk of death lurking around him. In business circles, numerous examples of risks facing business entrepreneurs are also legion. A company that owns a business premises where different types of manufactured goods are stored can be burnt down anytime. A bank could be robbed by armed robbers any moment, irrespective of the number of armed policemen mounting guard.

Definition and Classification of Risk

Many writers have defined the word risk in many ways, but for the purpose of this course, risk, according to Robert Imehr and Emerson Cammack is defined as the “uncertainty of loss”. That is, risk involves a situation where it is not certain when, where and how a loss or misfortune may occur.

Risk may be classified as:

1. Pure or speculative risk; 
2.  Fundamental or particular risk. 

Pure risk is one that gives rise to a loss or a loss situation. For example, if a car owner drives his car without sustaining an accident or injury to a third party. The owner does not suffer any loss. On the other hand, he may be involved in an accident. In this case, he suffers a loss.

Pure risk may arise from natural disaster. For example, earthquake, fire, thunder and lightening. It may also arise from human behaviour such as car theft, car accident, bank robbery, etc. These kinds of risks are generally insurable, that is, they can be covered by insurance companies. Speculative risk is one which gives rise to loss or gain or break-even situation. Examples are common in buying and selling of goods and shares, pools betting, gambling of all sorts, trade losses, possibility of a fall in demand etc. fall in the category of speculative risks. Generally, insurance companies do not insure speculative risks, that is, they are uninsurable.

Fundamental risk is one that arises from the society in which we live or from the physical occurrences beyond man’s control. Unemployment, war, changes in fashion, changes in customs and inflation are examples of fundamental risks that arise from the society in which we live. On the other hand, examples of physical occurrences beyond the control of man include earthquake, flood, tidal waves, volcanic gas emission; as the one that occurred at Nyos in Cameroon on 22nd August, 1986. Some fundamental risks are insurance while some are uninsurable. 

 The Concept and Process of Risk Management 

Risk management is a system among various functions of an organization whereby the risks threatening the assets and earnings of the organization can be identified, analysed and controlled in the most efficient and economic manner.

Risk management process takes a broader view of the problems, passed- by risks than does of the insurance. The process starts at a more fundamental level and asks the basic questions as to what risk this organization is exposed to.

It moves on from there to evaluate the likely impact on the organization by looking at both severity and frequency. Having identified the risk and evaluated it, risk management techniques are then applied to decide how this identified risk could best be controlled. This process is shown in the diagram below where we can see a simple representation of the various stages of risk management.

Risk Identification Techniques

Here, it is essential to carry out some kind of physical inspection. Having done this, one or more of the following may be a helpful aid to identifying risks:

1. Organizational charts; 
2. Flow charts; 
3. Checklist or questionnaire. 

An organizational chart will show the basic organizational structure of the plant or of an entire company. It will show the relationship between and among different personnel. For example, it could highlight weaknesses in organizational structure which could cause problems for the risk manager.

The flow chart is particularly useful in companies where the system of manufacture as production involves materials, flowing through a process. It shows the flow of the operation and can highlight problems which would be caused by unforeseen events.

The checklist involves the risk manager asking a number of questions about each stem of plant. These questions normally revolve around the risks to which the plant could be exposed.

 Risk Evaluation

Risk evaluation or analysis – The second stage in the risk management process is that of evaluating the impact of risks on the firm. Risks are often evaluated in a qualitative manner, that is, something which benefits from experience and the risk managers falls back on their own experience of similar events or situations in measuring the potential impact of risks. The method here involves statistical work which really begins with the keeping of adequate records.

Risk control is the third and final step in the risk management process as shown in Fig. 1. It should be recognized that this falls into two parts viz: physical and financial. The objective of a risk manager is the economic control of risk. After identifying and evaluating the risk, he can decide how best to respond to it.

Financial Control of Risks

This particular aspect could be divided into two categories, viz: retention and transfer.

Retention

This situation decides to retain the expectation of risks which are predictable and transfer the unpredictable to insurance. So the extent of this retention value the company becomes its own insurance. Also, in the case where the insured retains an excess or deductibles, this means that the insured retains the risk to the tune of this excess or deductibles. Alternatively, a separate fund could be set up to pay for losses or risk which may be fully retained. Such a fund is called self-insurance. Furthermore, new developed risk retention has been the formation of captive insurance companies, where large companies set up a subsidiary company to insure all the risks to which the parent company might be exposed.

Transfer

The second method of financial risk control is the situation in which the company transfers the effect of the loss to some other person or company. The most common form of risk transfer is by way of insurance. This is where the owner of the property is paying to her, the risk transferred to an insurance company. As earlier mentioned, this is only where insurance is concerned in the whole process of risk management.

Physical Control of Risks

Generally, this involves loss prevention which sometimes is referred to as risk reduction. It could be divided into two categories, namely:

1. Elimination, and 
2.  Minimisation of risk. 

Elimination

Many people think that the surest way of preventing losses is to eliminate the possibility of occurrence totally. A person who, for instance, is really concerned over the likelihood of a motor accident could sell the car, and so eliminate the risk. For some other domestic or business risks, their elimination will just not be possible.

Minimization

The thoughts on the inability to eliminate risk leads to how best losses can be minimized. This falls into two main divisions:

1.  Pre-loss minimization – This involves steps taken before the adverse events occur. 
2. Post-loss minimization – This takes place after the loss has occurred to minimize the severity or extent of loss. 

CONCLUSION

We have seen that no insurer or insured can afford to neglect risk management which has been defined as the process of growth and its effects on the growth process as well as on performance in the insurance market.

It is seen that the services of the intermediary increases the gross premium income of the insurers and consequently, contributes positively to the economy of the country.

This course material is designed to improve the information on which decisions are taken to help reduce risk. An insurer that is considering marketing a new product may seek to reduce uncertainty by conducting a market research, though given the limitation of such research, there can be no guarantee that actual outcome will match the expected results. In such circumstances, the need for past data, statistical information mainly on claims of insurance are to be charged from the experience gathered so far. This and any other data the insurer uses to charge future premium as a result of the severity and frequency of risk insured against. 

SUMMARY 

Risk management plays a significant role in the formulation of decision making in the method of risk financing. Risk financing may include risk transfer, i.e. reinsurance, co-insurance, premium loading etc. It is said that a risk with high loss frequency and severity can better be transferred through catastrophe excess of loss reinsurance. However, through risk evaluation, the insurer is able to classify its portfolio of risk in terms of frequency and severity for effective decision.