Risk management in various loss situations

Understanding risk and evaluating the options for managing it are crucial in the emerging Indian insurance setting, says Abhijit Roy.

WITH THE passage of the Insurance Regulatory & Development Authority (IRDA) Bill, the stage has been set for the entry of new players in the insurance field in India. However, even before their formal entry, a few international insurance majors have been instrumental in setting up risk management companies.

Risk management is much broader in concept than insurance. It can be defined as the systematic identification and analysis of the various loss exposures faced by a firm or individual and the best methods of treating the identified loss exposures consistent with the firm's or individual's objectives. Insurance is only one of the methods of treating risk exposures. Generally, a risk manager of a company is concerned only with the management of pure risks, not speculative risks.

Risk management is not a one-time activity. In a fast changing dynamic environment, the risk manager must remain alert to factors that affect his company. Hence he has to take the responsibility for periodic evaluation of risks as well as techniques for tackling various loss situations.

Objectives

Risk management can be divided into pre-loss stage and post-loss stage. The primary objective at the pre-loss stage is to prepare the firm for potential losses in the most economical way possible. A second objective is reduction of anxiety. The risk manager must also prepare the firm to meet any obligations imposed by outsiders. For example, insurers may want fire protection equipment installed, or a lending bank may require credit guarantee coverage.

The most important post-loss objective is to ensure survival of the firm in the event of a loss. Secondly, the firm has to resume operations as soon as possible. Ensuring stability of earnings is also important. Finally, the firm cannot forget its responsibility to the community in which it operates.

The process

There are basically four steps in the risk management process:

1. Identification of potential loss situations

2. Evaluation of potential losses

3. Selecting the appropriate techniques for tackling various loss exposures

4. Implementation of the risk management programme

Identification of Potential Losses:The following list covers major potential loss areas.

* Property losses including under fire, marine, motor insurance

* Liability losses

* Business income losses

* Losses relating to employee dishonesty

* Employee benefit loss exposures including workers' compensation, gratuity benefits, etc.

* Financial losses relating to exchange rate movements, adverse commodity price movements, etc.

Depending upon the size and breadth of operations of the firm, the risk manager has to identify various types of loss exposures. Many companies operate globally, and the role of the risk manager in identifying overseas risks is increasing. Risk identification usually starts with physical assets in the company's factories. Financial data on the firm's assets and operations also reveal the type of risks that need to be covered. Historical claims data reveal the actual experience of the company in loss exposures.Evaluation of potential losses: Once the potential losses are identified, the risk manager has to make an estimate of their frequency and severity in order to arrive at the impact of the losses on the company. Loss frequency refers to the probable number of losses that may occur during a given time period, say a year, while loss severity refers to the probable size of the losses that may occur. Once both these aspects are estimated, one can rank various types of loss exposures according to their relative importance. This type of ranking or mapping is also useful for arriving at the appropriate techniques to handle the loss exposures.

In order to estimate the severity of loss, two definitions are important. The maximum possible loss is defined as the worst possible loss that could possibly happen to the firm during its lifetime. This is a single catastrophic loss that could wipe out the firm. The maximum probable loss is the worst loss that is likely to happen.

Selection of appropriate technique to handle loss exposures: The major techniques for handling loss exposures are:

* Avoidance

* Loss Control

* Retention

* Non-insurance transfers

* Insurance

Avoidance would imply that a loss exposure is not acquired, or an existing loss exposure is abandoned. Suppose an area is prone to earthquakes. A power generating company may decide not to put up a hydro power plant in the earthquake prone zone. However, if the earthquake prone zone were also the area where the river runs through a valley, avoiding the area would also mean abandoning the plan to build a hydro power plant using damming of the river to generate the electricity. The company may finally decide to build the power plant taking suitable precautions.

Loss control activities are designed to reduce both the severity and frequency of loss exposures. Burglar alarm systems will not prevent burglary under all circumstances; but they do reduce the frequency of losses due to burglary. Similarly, fire protection systems should reduce the severity of losses attributable to fire. Of course many loss control measures are quite complicated, and experts may have to be brought in to get the best results.

Retention of risks: Retention implies that the company retains part or all of the possible losses that may result from a given loss exposure. Quite often a company may retain the risks by default, that is, it is not aware of the risks. Here risk retention is that which the risk manager is undertaking after being fully aware of the loss exposures.

Risk retention may become necessary because no other treatment is possible. For example, the coverage may be too expensive. It may not be possible to insure or transfer the risk. Another situation where retention is recommended is where even in the worst possible situation, the loss is not serious. If a risk manager retains the losses, he has to estimate the money value of the losses. If the retention method is used, the company should follow an acceptable method of funding the losses that will arise as a result. The company can decide to pay for the losses out of the current income. However, this may mean substantial variation from year to year. Some companies use the approach of funding a reserve to take care of such variations.

Sometimes retention of risks is also known as self-insurance. For example, the company instead of taking out health insurance may meet the health care needs of its employees directly. This may be on account of pressure from labour unions, or it may be because the company finds it cheaper to do so. However, the risk manager needs to consider all aspects of retention carefully. Retention may lead to overall savings of money, but it may also lead to possible higher losses. One usual advantage of retention is that there is a greater incentive for loss prevention. The risk manager can also go in for small retention in the form of a deductible while arranging for insurance.

A deductible is used to eliminate small claims and the administrative hassles of adjusting these small claims. Agreeing for deductibles may lead to substantial savings in premium payments.

A sophisticated method of taking care of such losses has been the concept of `captive insurer'. A captive insurer is established and owned by a parent firm for the purpose of insuring the latter's loss exposures. Many captives are located at offshore centres like Bermuda on account of tax and other regulatory advantages. In India `captive insurers' are not possible on account of regulatory reasons, but in future as the market evolves such things may become possible.

Non-Insurance Transfers: As the name implies, these relate to transfer of potential risks to third parties. For example, the purchase of computers by a firm can be accompanied by a maintenance contract. Similarly, while setting up a new plant the contractor may agree to be responsible for any damage to the plant during the construction stage. Another type of non- insurance risk transfer is to hedge price risks by using derivative contracts. Such non-insurance transfers are often very useful as the potential loss may be shifted to some one who is in a better position to exercise loss control.

Insurance: After considering the above four techniques of handling risk exposures, the risk manager has to use insurance to tackle the remaining loss exposures. The risk manager has to select the insurance coverage required and then identify a suitable insurer. Once the terms are negotiated with the insurer, the details of the coverage should be disseminated to appropriate persons in the organisation. The risk manager's work does not end here. There has to be a periodic review of the entire programme so that emerging scenarios can be tackled appropriately.

In order to understand the risk management process, in the accompanying table we have considered in a simple form various types of losses in terms of loss frequency and loss severity.

Planning is often easier than implementation. In order to ensure success, a risk management programme has to be properly implemented and administered. The risk manager also cannot act in isolation. He has to have the close co-operation of various departments to make a success of the entire programme.

The ability to handle different types of risk scenarios has become a key element in the success of corporates in a modern economy. Firms today face rapid changes in demand patterns, obsolescence of equipment and technology, and movements in exchange rates and in international commodity prices. In this scenario, it is difficult for the average risk manager to remain cognisant of the latest developments in the risk management field. Understanding physical risks is only one part of his job.

In such a situation a company often finds it useful to appoint an outside expert to identify and evaluate potential loss areas. Multinational insurance companies have developed advanced techniques to map and analyse various types of risks that a company may face. Today's customers require risk assessments that go well beyond typical insurance coverages. A corporate may require a `total risk profiling' analysis to take into account a range of both operational and financial risks.

Advanced modelling techniques are used to identify the best options for a company to mitigate the risk exposures, given the resource constraints. Insurance companies offer such services to their clients. With the entry of foreign insurance majors, Indian companies can also take advantage of the latest developments globally. Already a few of the global majors like Allianz, AIG and Zurich Financial Services have started offering risk management services in India.

The ability to handle different types of risk scenarios has become a key element in the success of corporates in a modern economy.

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