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Executive Summary
As the drama of life unfolds on the path from birth to death, people experience unpredictable
events along the way. Not all events are same for every one and we soon learn that life is
uncertain and death is indeterminable. The paradox is that we know we cannot predetermine how
long our life will be, yet we know that death is certainly for everyone. Thus life is full of
uncertainties and such uncertainties translate in to risks.
Although insurance is a formidable risk management tool but from an insurers point of view it is
very critical to assess the risk associated to an individuals life in an appropriate and accurate
manner.
The ensuing study is an attempt to provide the greater insight to the use of rules and techniques
of risk assessment in the context of risk management process followed by ICICI Prudential Life
Insurance Company. It is divided in to five chapters. The first chapter looks at the details of
ICICI Prudential as a company because unless or until we are known to the company profile to
which we are going to study, we cannot move in the right direction. After a brief look at the
company profile, chapter 2 deals with the basics of Risk Management. Chapter 3 elucidates the
relationship between insurance and risk and how insurance can be applied as a formidable tool to
risk management. Chapter 4 illustrates the Risk Management Process. Chapter 5 illustrates the
importance, methodology and application of underwriting tools and underwriting process used
by the life insurance company.
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Certificate
This is to certify that the dissertation entitled Risk Assessment & Underwriting of an
Insurance Proposalsubmitted by VAIBHAV TRIVEDI( DS79-F-095), MBA 2 years course,
Session 2007-2009) to the Indian Institute of Planning & Management, New Delhi been
authentically done by him under my supervision and guidance with due diligence.
The dissertation has been undertaken in fulfillment of the degree requirements for Masters
in Business Administration, Indian Institute of Planning & Management, New Delhi.
Mr. Paramjeet Singh Ahuja
Branch Underwriter, Noida
ICICI Prudential Life Insurance Co
Date :
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Acknowledgement
I would like to express my sincere gratitude to my project guide Mr. Paramjeet Singh Ahuja
for his constant interest and guidance towards the successful completion of the project. I would
also like to acknowledge the support provided by the Central Underwriting Team (CUW) of
ICICI Prudential Life Insurance Company Private Ltd. Lastly, I would like to thank Mr. Nitin
Malhotra, the State Manager U.P, ICICI Prudential Life Insurance Company for helping me out
to get connected with the CUW team and for making available crucial information regarding the
guidelines followed by the company to underwrite an insurance proposal.
I also express my grateful appreciation to Prof. Sumanta Sharma & Mr. Vijay Boddu for
providing guidance throughout my thesis work.
Last but not the least, it is a pleasure to express my heartfelt thanks to all those who remembered
and wished every success in my endeavor.
VAIBHAV TRIVEDI
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INTRODUCTION TO THE STUDY
Introduction
This is an overall study of the rules and methods adopted by the organization of ICICI Prudential
Life Insurance Company Pvt. Ltd. for the purpose of underwriting of an Insurance Proposal.
Objectives
The study has undertaken to get an exposure of actual working environment in an organization.
The main objective of the study is to familiarize with the frame work and methods of
organization, used for underwriting.
1. To provide greater insight to the use of rules and techniques of risk assessment in thecontext of risk management process.
2. To know how ICICI Prudential Life works and methods adopted for the purpose ofunderwriting of an insurance proposal.
Methodology
1. In-depth study of underwriting principles and guidelines.
2. Understanding the requirement of ICICI Prudential Life Insurance Company toassess the risk faced by a prospect.
3. Study pros & cons of the decentralized approach of underwriting of an insuranceproposal at branch level.
Limitation
The following limitation of this internship report:
1. The study is limited to the study of the underwriting department and not on whole oforganization.
2. This study is only subject to an organization and not consist the whole market.
3. The study is time bound and would be applicable to current scenario.
4. It is assumed that the information provided by the company is corrected andreference is drawn accordingly.
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5. Thesis Topic Approval ( F ) SS/ 2007-09
DearVaibhav Trivedi,
This is to inform that the thesis topic Risk Assessment & Underwriting of an Insurance
Proposal ( ICICI Prudential Company' Approach), as proposed by you, has been
approved .This email is an official confirmation that you would be doing your thesis work
under the guidance of Mr. Paramjeet Singh Ahuja. Make it a comprehensive thesis; the
objective of a thesis should be value addition to the existing knowledge base.
Please ensure that the objectives as stated by you in your synopsis are met using the appropriate
research design. You must always use the thesis title as approved and registered with us.
Your Alumni ID Number is DS79-F-095
You are required to correspond with us by sending at least six response sheets to Prof. Vijay Kr.
Boddu at [email protected] Ph-011-42789931 ( format attached along with this
mail) at regular intervals, before 30th April 2009(the last date for thesis submission).
Regards,
Sumanta Sharma
Dean (Projects)
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The Indian Institute of Planning and Management
New Delhi
TABLE OF CONTENTS
CHAPTER 1: DETAILS OF ICICI PRUDENTIAL LIFE INSURANCE COMPANY
1.1 Overview -------------------------------------------------------------------------------11.2 The ICICI Prudentials Edge-------------------------------------------------------- 21.3 Vision & Mission Statement of the Company-------------------------------------31.4 Promoters of the Company-----------------------------------------------------------41.5 Fact Sheet of the Company
` 1.5.1 The Company------------------------------------------------------------ 51.5.2 Distribution -------------------------------------------------------------- 61.5.3 Products------------------------------------------------------------------ 7
1.6 Parent Organization in India------------------------------------------------------- 131.7 Board of Directors & Management Team----------------------------------------- 14
CHAPTER 2: RISK MANAGEMENT AN INTRODUCTION
2.1 Meaning of Risk---------------------------------------------------------------------- 162.2 Categories of Risk-------------------------------------------------------------------- 16
2.2.1 Statics & Dynamic Risks----------------------------------------------- 162.2.2 Fundamental & Particular Risks---------------------------------------172.2.3 Pure & Speculative Risks-----------------------------------------------18
2.3 Nature of Insurable Risk------------------------------------------------------------- 182.4 Pure Risks------------------------------------------------------------------------------18
2.4.1 Personal Risks------------------------------------------------------------192.4.2 Property Risks------------------------------------------------------------192.4.3 Liability Risks------------------------------------------------------------192.4.4 Failure of others----------------------------------------------------------19
2.5 Methods of Handling Risk-----------------------------------------------------------202.5.1 Avoiding Risk------------------------------------------------------------212.5.2 Controlling Risk-------------------------------------------------------- -212.5.3 Accepting Risk-----------------------------------------------------------21
2.5.4 Transferring Risk-------------------------------------------------------- 22
CHAPTER 3: INSURANCE & RISK
3.1 Basic Characteristics of Insurance--------------------------------------------------253.1.1 Pooling of Losses--------------------------------------------------------253.1.2 Indemnification---------------------------------------------------------- 263.1.3 Risk Transfer-------------------------------------------------------------27
3.2 Requirements of Insurable Risks--------------------------------------------------- 28
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3.3 Advantages & Disadvantages of Insurance in Handling Risk------------------ 31
CHAPTER 4: RISK MANAGEMENT PROCESS
4.1 Meaning and Objective of Risk Management-------------------------------------354.2 Nature of Risk Management---------------------------------------------------------37
4.3 Six Steps Risk Management Process-----------------------------------------------384.4 Risk Control & Risk Financing----------------------------------------------------- 42
CHAPTER 5: UNDERWRITING OF AN INSURANCE PROPOSAL
5.1 Insurance Market Dynamics---------------------------------------------------------445.2 Underwriting Cycle & Underwriting Guidelines--------------------------------- 445.3 Life Insurance Underwriting---------------------------------------------------------475.4 Sources of Underwriting Information---------------------------------------------- 505.5 Methods of Underwriting------------------------------------------------------------ 51
Underwriting guidelines followed by ICICI Prudential Life Insurance Company--59
BIBLIOGRAPHY
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CHAPTER 1: ICICI PRUDENTIAL LIFE INSURANCE COMPANY
1.1 Overview
ICICI Prudential Life Insurance Company is a joint venture between ICICI Bank - one of India's
foremost financial services companies-and Prudential plc - a leading international financial
services group headquartered in the United Kingdom. Total capital infusion stands at Rs. 37.72
billion, with ICICI Bank holding a stake of 74% and Prudential plc holding 26%.
ICICI Prudential began its operations in December 2000 after receiving approval from
Insurance Regulatory Development Authority (IRDA). Today, its nation-wide team comprises
of over 952 branches in addition to 1,004 micro-offices, over 291,000 advisors; and 21
bancassurance partners.
ICICI Prudential was the first life insurer in India to receive a National Insurer Financial
Strength rating of AAA (Ind) from Fitch ratings. For three years in a row, ICICI Prudential has
been voted as India's Most Trusted Private Life Insurer, by The Economic Times - AC Nielsen
ORG Marg survey of 'Most Trusted Brands'. As it grows its distribution, product range and
customer base, it continues to tirelessly uphold its commitment to deliver world-class financial
solutions to customers all over India.
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1.3 ICICI Prudentials Vision
To be the dominant Life, Health and Pensions player built on trust by world-class people andservice.
The company hopes to achieve this by:
Understanding the needs of customers and offering them superior products and
service
Leveraging technology to service customers quickly, efficiently and conveniently
Developing and implementing superior risk management and investment
strategies to
offer sustainable and stable returns to our policyholders
Providing an enabling environment to foster growth and learning for our
employees
And above all, building transparency in all our dealings
The success of the company will be founded in its unflinching commitment to 5 core values
Integrity, Customer First, Boundary less, Ownership and Passion. Each of the values describes
what the company stands for, the qualities of our people and the way we work.We do believe that we are on the threshold of an exciting new opportunity, where we can play a
significant role in redefining and reshaping the sector. Given the quality of our parentage and the
commitment of our team, there are no limits to our growth.
ICICI Prudentials Values
Every member of the ICICI Prudential team is committed to 5 core values: Integrity, Customer
First, Boundaryless, Ownership, and Passion. These values shine forth in all we do, and have
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become the keystones of our success.
1.4 Promoters of the ICICI Prudential Life Insurance Company
ICICI Bank
ICICI Bank Limited (NYSE:IBN) is India's largest private sector bank and the second largest
bank in the country, with consolidated total assets of $121 billion as of March 31, 2008. ICICI
Banks subsidiaries include Indias leading private sector insurance companies and among its
largest securities brokerage firms, mutual funds and private equity firms. ICICI Banks presence
currently spans 19 countries, including India.
Prudential Plc
Established in London in 1848, Prudential plc, through its businesses in the UK, Europe, US,
Asia and the Middle East, provides retail financial services products and services to more than 20
million customers, policyholder and unit holders and manages over 267 billion of funds
worldwide (as of December 31, 2007). In Asia, Prudential is the leading European life insurance
company with life operations in China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia,
the Philippines, Singapore, Taiwan, Thailand, and Vietnam. Prudential is one of the largest retail
fund managers for Asian sourced assets ex-Japan. Its fund management business has expanded
into ten markets, comprising of China, Hong Kong, India, Japan, Korea, Malaysia, Singapore,
Taiwan, Vietnam and United Arab Emirates.
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1.5 Fact Sheet of ICICI Prudential Life Insurance
1.5.1 The Company
ICICI Prudential Life Insurance Company is a joint venture between ICICI Bank, a premier
financial powerhouse, and Prudential plc, a leading international financial services group
headquartered in the United Kingdom. ICICI Prudential was amongst the first private sector
insurance companies to begin operations in December 2000 after receiving approval from
Insurance Regulatory Development Authority (IRDA).ICICI Prudential Life's capital stands at Rs. 37.72 billion (as on March, 2008) with ICICI Bank
and Prudential plc holding 74% and 26% stake respectively. For the year ended March 31, 2008,
the company garnered Retail New Business Weighted premium of Rs. 6,684 crores, registering a
growth of 68% over the last year and has underwritten nearly 3 million retail policies during the
period. The company has assets held over Rs. 28,500 crore.ICICI Prudential Life is also the only private life insurer in India to receive a National Insurer
Financial Strength rating of AAA (Ind) from Fitch ratings. The AAA (Ind) rating is the highest
rating, and is a clear assurance of ICICI Prudential's ability to meet its obligations to customers
at the time of maturity or claims.For the past seven years, ICICI Prudential Life has retained its leadership position in the life
insurance industry with a wide range of flexible products that meet the needs of the Indian
customer at every step in life.
1.5.2 Distribution
ICICI Prudential Life has one of the largest distribution networks amongst private life insurers in
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India. It has a strong presence across India with over 952 branches in addition to 1,004 micro-
offices and an advisor base of 291,000.
The company has 21 bancassurance partners having tie-ups with ICICI Bank, Bank of India,
Federal Bank, South Indian Bank, Shamrao Vitthal Co-Op Bank, Jalgaon Peoples Co-op Bank,
Ernakulam District Co-op Bank, Idukki District Co-op Bank, Ratnagiri Sindhudurg Gramin
Bank, Solapur Gramin Bank, Wainganga Kshetriya Gramin Bank, Aryawart Gramin Bank,
Jharkhand Gramin Bank, Narmada Malwa Gramin Bank, Baitarani Gramya Bank, Ratnagiri
District Central Co-op Bank, Seva Vikas Co-op Bank, Sangli Urban Co-Operative Bank,
Baramati Co-operative Bank, Ballia Kshetriya Co-Operative Bank, The Haryana State Co-
Operative Bank and Imphal Urban Cooperative Bank Ltd.
1.5.3 Products
Insurance Solutions for Individuals
ICICI Prudential Life Insurance offers a range of innovative, customer-centric products that meet
the needs of customers at every life stage. Its products can be enhanced with up to 4 riders, to
create a customized solution for each policyholder.Savings & Wealth Creation Solutions
Save'n'Protect is a traditional endowment savings plan that offers life protection
along with adequate returns.
CashBakis an anticipated endowment policy ideal for meeting milestone expenses
like a child's marriage, expenses for a child's higher education or purchase of an asset. It
is available for terms of 15 and 20 years.
LifeTime Gold & LifeTime Plus are unit-linked plans that offer customers the
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flexibility and control to customize the policy to meet the changing needs at different
life stages. Each offer 6 fund options - Preserver, Protector, Balancer, Maximiser, Flexi
Growth and Flexi Balanced.
LifeLink Super is a single premium unit linked insurance plan which combines life
insurance cover with the opportunity to stay invested in the stock market.
Premier Life Gold is a limited premium paying plan specially structured for long-
term wealth creation.
InvestShield Life New is a unit linked plan that provides premium guarantee on the
invested premiums and ensures that the customer receives only the benefits of fund
appreciation without any of the risks of depreciation.
InvestShield Cashbakis a unit linked plan that provides premium guarantee on the
invested premiums along with flexible liquidity options.
LifeStage RP is a unique and powerful wealth creation insurance solution, which
combines the benefits of automatic asset allocation and quarterly rebalancing along with
increased protection.
Protection Solutions
LifeGuard is a protection plan, which offers life cover at low cost. It is available in 3
options - level term assurance, level term assurance with return of premium & single
premium.
HomeAssure is a mortgage reducing term assurance plan designed specifically to help
customers cover their home loans in a simple and cost-effective manner.
Education insurance plans
Education insurance under the SmartKid brand provides guaranteed educational
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benefits to a child along with life insurance cover for the parent who purchases the
policy. The policy is designed to provide money at important milestones in the child's
life. SmartKid plans are also available in unit-linked form - both single premium and
regular premium.
Retirement Solutions
ForeverLife is a traditional retirement product that offers guaranteed returns for the
first 4 years and then declares bonuses annually.
LifeTime Super Pension is a regular premium unit linked pension plan that helps one
accumulate over the long term and offers 5 annuity options (life annuity, life annuity
with return of purchase price, joint life last survivor annuity with return of purchase
price, life annuity guaranteed for 5, 10 and 15 years & for life thereafter, joint life, last
survivor annuity without return of purchase price) at the time of retirement.
LifeLink Super Pension is a single premium unit linked pension plan.
Immediate Annuity is a single premium annuity product that guarantees income for
life at the time of retirement. It offers the benefit of 5 payout options.
PremierLife Pension is a unique and convenient retirement solution with a limited
premium paying term of three or five years, to suit professionals and businessmen,
especially those who require more flexibility and customization while planning their
finances.
Health Solutions
Health Assure Plus: Health Assure is a regular premium plan which provides long
term cover against 6 critical illnesses by providing policyholder with financial
assistance, irrespective of the actual medical expenses. Health Assure Plus offers the
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added advantage of an equivalent life insurance cover.
Cancer Care: is a regular premium plan that pays cash benefit on the diagnosis as
well as at different stages in the treatment of various cancer conditions.
Cancer CarePlus: is a wellness plan that includes all the benefits of Cancer Care and
also provides an additional benefit of free periodical cancer screenings.
Diabetes Care: Diabetes Care is a unique critical illness product specially developed
for individuals with Type 2 diabetes and pre-diabetes. It makes payments on diagnosis
on any of 6 diabetes related critical illnesses, and also offers a coordinated care approach
to managing the condition. Diabetes Care Plus also offers life cover.
Diabetes Care Plus: is a unique insurance policy that provides an additional benefit of
life cover for Type 2 diabetics and pre-diabetics
Hospital Care: is a fixed benefit plan covering various stages of treatment
hospitalisation, ICU, procedures & recuperating allowance. It covers a range of medical
conditions (900 surgeries) and has a long term guaranteed coverage upto 20 years.
Crisis Cover : is a 360-degree product that will provide long-term coverage against 35
critical illnesses, total and permanent disability, and death.
Group Insurance Solutions
ICICI Prudential Life also offers Group Insurance Solutions for companies seeking to
enhance benefits to their employees.
Group Gratuity Plan: ICICI Prudential Life's group gratuity plan helps employers \
fund their statutory gratuity obligation in a scientific manner. The plan can also be
customized to structure schemes that can provide benefits beyond the statutory
obligations.
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Group Superannuation Plan: ICICI Prudential Life offers both defined
contribution
(DC) and defined benefit (DB) superannuation schemes to optimise returns for the
members of the trust and rationalise the cost. Members have the option of choosing
from various annuity options or opting for a partial commutation of the annuity at the
time of retirement. Group Immediate Annuities: In addition to the annuities offered to existing
superannuation customers, we offer immediate annuities to superannuation funds not
managed by us.
Group Term Plan: ICICI Prudential Life's flexible group term solution helps
provide
affordable cover to members of a group. The cover could be uniform or based on
designation/rank or a multiple of salary. The benefit under the policy is paid to the
beneficiary nominated by the member on his/her death.
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Flexible Rider Options
ICICI Prudential Life offers flexible riders, which can be added to the basic policy at a marginal
cost, depending on the specific needs of the customer.
1. Accident & disability benefit: If death occurs as the result of an accident during the
term of the policy, the beneficiary receives an additional amount equal to the rider
sum assured under the policy. If an accident results in total and permanent disability,
10% of rider sum assured will be paid each year, from the end of the 1st year after
the disability date for the remainder of the base policy term or 10 years, whichever is
lesser. If the death occurs while travelling in an authorized mass transport vehicle,
the beneficiary will be entitled to twice the sum assured as additional benefit.
2. Critical Illness Benefit: protects the insured against financial loss in the event of 9
specified critical illnesses. Benefits are payable to the insured for medical expenses
prior to death.
3. Waiver of Premium: In case of total and permanent disability due to an accident,
the future premiums continue to be paid by the company till the time of maturity.
This rider is available with SmartKid, LifeTime Plus, LifeTime Super and LifeTime
Super Pension.
4. Income benefit rider: In case of death of the life assured during the term of the
policy, 10% of the sum assured is paid annually to the nominee on each policy
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anniversary till the maturity of the rider.
1.6 About the Promoter, Parent Organization of ICICI Prudential Life Insurance in INDIA
ICICI Bank
ICICI Bank Limited (NYSE:IBN) is India's largest private sector bank and the second largest
bank in the country, with consolidated total assets of $121 billion as of March 31, 2008. ICICI
Banks subsidiaries include Indias leading private sector insurance companies and among its
largest securities brokerage firms, mutual funds and private equity firms. ICICI Banks presence
currently spans 19 countries, including India.Established in London in 1848, Prudential plc, through its businesses in the UK and Europe, US,
Asia and the Middle East, provides retail financial services products and services to more than 20
million customers, policyholder and unit holders and manages over 267 billion of funds
worldwide (as of December 31, 2007). In Asia, Prudential is the leading European life insurance
company with life operations in China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia,
the Philippines, Singapore, Taiwan, Thailand, and Vietnam. Prudential is one of the largest retail
fund managers for Asian sourced assets ex-Japan. Its fund management business has expanded
into a total of ten markets: China, Hong Kong, India, Japan, Korea, Malaysia, Singapore,
Taiwan, Vietnam and United Arab Emirates.Its fund management business has expanded into a total of ten markets: China, Hong
Kong, India, Japan, Korea, Malaysia, Singapore, Taiwan, Vietnam and United Arab Emirates.
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1.7 Board of Directors
The ICICI Prudential Life Insurance Company Limited Board comprises reputed people from the
finance industry both from India and abroad.
Mr. K. V. Kamath, Chairman
Ms. Kalpana Morparia, Vice Chairperson
Ms. Chanda Kochhar, Director
Mr. Barry Stowe, Director
Mr. H.T. Phong, Director
Prof. Marti G. Subrahmanyam, Director
Mr. Mahesh Prasad Modi, Director
Ms. Rama Bijapurkar, Director
Mr. Keki Dadiseth, Director
Ms. Shikha Sharma, Managing Director
Mr. N.S. Kannan, Executive Director
Mr. Bhargav Dasgupta, Executive Director
Management Team
The ICICI Prudential Life Insurance Company Limited Management team comprises reputed
people from the finance industry both from India and abroad.
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Mr.V.Vaidyanathan, Managing Director & CEO
Mr. N. S. Kannan, Executive Director
Mr. Bhargav Dasgupta, Executive Director
Ms. Anita Pai, Exec. Vice President Customer Service & Tech.
Dr. Avijit Chatterjee, Appointed Actuary
Mr. Puneet Nanda, Exec. Vice President & Chief Investment Officer
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CHAPTER 2: RISK MANAGEMENT AN INTRODUCTION
2.1 Meaning of Risk
Risk is a condition where there is a possibility of an adverse deviation from a desired outcome
that is expected or hoped for; when an event is stated to be possible, it has a probability between
zero and one; it is neither impossible nor indefinite. The degree of risk may or may not be
measurable. Since our purpose is to relate risk to insurance, focus will be on risk, which entails
the possibility of financial loss. Financial loss may be defined as a decline in or disappearance of
value due to a contingency. This means that if the loss of value is intended or if it is certain, it is
not a loss with in the context of above definition.
For those who define risk as uncertainty, the greater the uncertainty, the greater is the risk. For an
individual, higher the probability of loss, greater is the probability of an adverse deviation from
what is hoped for and therefore greater is the risk. The expected value of loss in a given situation,
or the mathematical value of risk at any point of time, is the probability of the loss materializing
multiplied by the amount of the potential or anticipated loss.
2.2 Categories of Risk
There is some element of risk in every aspect of human endeavor, and many of these risks have
no (or only incidental) financial consequences. As for insurance, we are concerned with those
risks that involve a financial loss.
2.2.1 Statics and dynamic risks
Dynamic risks are those resulting from changes in the economy. Changes in the price level,
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consumer tastes, income and output and technology may cause financial loss to the members of
the economy. These dynamic risks normally benefit society over the long run since they are the
result of adjustments to misallocation of resources. Since these dynamic risks may affect a large
number of individuals, they are generally considered less predictable than static risks, since they
do not occur with any precise degree of regularity.
Static risks involve those losses that occur even if there were no changes in the economy. If we
could hold consumer tastes, output and income and the level of technology, constant, some
individuals would still suffer financial loss. These losses arise from causes other than the
changes in the economy, such as perils of nature and dishonesty of other individuals. Unlike
dynamic risks, static risks are not a source of gain to society. Static losses tend to occur with a
degree of regularity over time and, as a result, are generally predictable. Because they are
predictable, static risks are more suited to treatment by insurance than are dynamic risks.
2.2.2 Fundamental and particular risks
Fundamental risks involve losses that are impersonal in origin and consequences. They are
group risks, caused for the most part in economic, social and political phenomena, although they
may also result from physical occurrences. They affect large segments or even all of the
population. Unemployment, war, inflation, earthquakes and floods are all fundamental risks.
Particular risks involve losses that arise out of individual events and are felt by the individuals
rather than by the entire group. They may be static or dynamic. The burning of a house and the
robbery of a bank are particular risks.
Since fundamental risks are caused by the conditions more or less beyond the control of
individuals who suffer the losses and since they are not due to the fault of any one in particular, it
is held that society rather than the individual has responsibility to deal with them social
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insurance should be for fundamental risk private insurance for particular risks though some
fundamental risks like earthquake are covered by private insurance.
2.2.3 Pure & speculative Risks
Speculative riskrefers to a condition where there is a chance that the risk-taker may suffer a
loss or enjoy a gain or maintain status quo. For example, if Jayesh purchase a lottery ticket, he
runs the risk of either losing the money used to buy the ticket or striking the top prize of Rs. 1
crore. This would be an example of taking speculative risk. When an investor invests a sum of
money in to certain shares, he could end up making a profit, suffering a loss or breaking even.
He has also undertaken a speculative risk.
Pure riskrefers to a condition where the risk taker either suffers a loss or avoids losses without
enjoying any gain. For example, if Jayesh owns a property, there is a risk that an accidental fire
may decimate it. This is an example of pure risk as the best that Jayesh can hope for is to
maintain status quo and ensure that the property is safe.
2.3 Nature of Insurable Risk
Only pure risks are insurable. Insurance is not concerned with protection of individuals against
those losses arising out of speculative risks. Speculative risk is voluntarily accepted because of
its two-dimensional nature, which includes the possibility of gain.
2.4 Pure Risk
Pure risk can be classified in to four categories:1. Personal Risks2. Property Risks3. Liability Risks4. Failure of others
2.4.1 Personal Risks
These are risks that affect the income-producing ability of the client arising from events
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such as employment, death, disability, illness or accident. They can also cause the client
to incur additional expenses relating to his maintenance and sustenance. For example, if
a client is struct by disability, then he will not only be economically unproductive, but
additional expenses, e.g. medical expenses, will be incurred to look after his needs
arising from the disability.
2.4.2 Property Risks
These are risks that result in loss, destruction or damage to the clients real and personal
property. Examples of such risks are fire, theft, flood and accidents.
2.4.3 Liability Risks
These are risks that expose the client to liability to third parties. They arise as a result of
the clients words, conduct, property or legal relationships. For example, if client is a
lawyer, he owes a duty of care to his client to give proper advice. If this duty is breached
and client suffers losses, he could be liable for damages. Another example is where a
person negligently steers his car and cause an accident resulting in injuries inflicted on a
pedestrian. The driver will be liable to the pedestrian for damages to compensate him for
any pain or loss suffered.
2.4.4 Failure of others
These are risks that expose the client to loss due to the acts or omission by others. For
example, if a person engages a contractor to renovate his home but the contractor
botches up (spoil) the job, resulting in extensive damage to the home to the person will
have to suffer losses due to the contractors negligence. The situation will be
exacerbated (worsened) if the contractor is impecunious (poor), as any legal action
instituted against him will probably not result in any compensation for the client.
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2.5 Methods of Handling Risk
We are surrounded by risks. We take risk when we travel, when we engage in recreational
activities, even when we breathe. Some risks are significant, others are not. When we decide to
leave an umbrella at home, we take the risk that we might get caught in a rain shower. Such a
risk is insignificant. But what about the risks in the following situations?
1. Ricky Agarwal is a 23-year old single man who is working his way through
college with part time jobs. What if he becomes ill and requires a long hospitalstay and expensive medical treatment?
2. Dinesh and Jaya Patel are working parents of two school-aged children. What ifeither Dinesh or Jaya becomes disabled and cannot work to support the family?
3. Jagdish and Jayendra Goswami own and mange a convenience store. What if afire damages their building?
4. The Wilson Software Development Companys product development processdepends on the genius of two employees who are computer whizzes. Whathappens to the company if one or both of them dies?
5. Kavita Waghmare is an artist who supports herself by selling her artwork. Whathappens when she retires and her income is no longer sufficient to meet hereconomic needs?
In each situation, the individual, family or business can use risk management to deal with the
financial risk it faces. The practice of risk management involves identifying risk, assessing risk
and dealing with risk. In order to eliminate or reduce our exposure to financial risk, we can do at
least four things:1. Avoid Risk2. Accept Risk3. Control Risk4. Transfer Risk
2.5.1 Avoiding Risk
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The first, and perhaps most obvious, method of managing risk is simply to avoid risk
altogether. We can avoid the risk of personal injury that may result from an airplane
crash by not riding in an airplane, and we can avoid the risk of financial loss in the stock
market by not investing in it. Sometimes, however, avoiding risk is not effective or
practical.
2.5.2 Controlling Risk
We can try to control risk by taking steps to prevent or reduce losses. For instance,
Jagdish and Jayendra Goswami in one of our earlier examples could reduce the
likelihood of a fire in their convenience store by banning smoking in their building. In
addition, the Goswamis could install smoke detectors and a sprinkling system in their
building to lessen the extent of damage likely to happen if there is a fire. In these ways,
the Goswamis are attempting to control risk by reducing the likelihood of a loss and
lessening the severity of a potential loss.
2.5.3 Accepting Risk
A third method of managing risk is to accept, or retain risk. Simply stated, to accept a
risk is to assume all financial responsibility for that risk. Sometimes, as in the case of an
insignificant risk loosing an umbrella the financial loss is not great enough to
warrant much concern. We assume the cost of replacing the umbrella ourselves. Some
people consciously choose to accept more significant risks. For instance, a couple like
Dinesh and Jaya Patel from one of the previous examples may decide not to purchase
disability income insurance because they believe they can just reduce their standard of
living if one of them become disabled.
Individuals and business sometimes decide to accept total responsibility for a given risk
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rather than purchasing insurance to cover the risk. In this situation, the person or
business is said to self-insure against the risk. Self-is a risk management technique by
which a person or a business accepts financial responsibility for losses associated with
specific risks. For example, many employers provide medical expense benefits to heir
employees. An employer can self-insure the benefit plan by setting aside money to pay
employees medical expenses or can pay those expenses out of its current income.
Individuals and business can also decide to accept only a part of the risk. For instance,
an employer can partially self-insure a medical expense benefit plan by paying its
employees medical expenses up to a stated amount and buying insurance to cover all
expenses in excess of that stated amount. Many employers now use self-insurance to
fund their employees health insurance plans.
2.5.4 Transferring Risk
Transferring risk is a fourth method of risk management. When you transfer risk to
another party, you are shifting the financially responsibility for that risk to the other
party, generally in exchange for a fee. The most common way for individuals, families
and business to transfer risk is to purchase insurance coverage.
When an insurance company agrees to provide a person or a business with insurance
coverage, the insurer issues an insurance policy. The policy is a written document that
contains the terms of the agreement between the insurance company and the owner of
the policy. The agreement is a legally enforceable contract under which the insurance
company agrees to pay a certain amount of money known as the policy benefit, or the
policy proceeds when a specific loss occurs, provided that the insurer has received a
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specific amount of money, called the premium.
In general, individuals and business can purchase insurance policies, which covers three
types of risks: property damage risk, liability risk and personal risk.
Insurers that sell insurance policies to provide financial security from property damage
risk and liability risk are known as Property-casualty or property-liability, insurance
companies.
Property insuranceprovides a benefit if the insured items are damaged or lost because
of various specified perils, such as fire, theft or accident.
Liability insuranceprovides a benefit payable on behalf of a covered party who is
legally responsible for unintentionally harming others or their property.
Property insurance or life insurance (also referred to as property and casualty insurance)
are commonly marked together in one policy. Suppose, for example, you are driving a
car that is covered by an automobile property-liability insurance policy and you
accidentally crash through your neighbors front door. The damage to your neighbors
home will be paid by your policys liability coverage; the money to repair your car will
come from your policys property coverage.
Personal insurance; Insurers that sell insurance policies to provide financial security
from personal risk are known as life and health insurance companies. It is the transfer of
personal risk to life and health insurers that we will address in this book. Both
individuals and business purchase life and health insurance policies to provide
themselves with the financial security provided by these products.
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CHAPTER 3: INSURANCE AND RISK
3.1 Basic Characteristics of Insurance
The business of insurance is related to the protection of the economic value of assets. Every asset
has a value. The asset would have been created through the efforts of the owner, in the
expectation that, either through the income generated there from or some other output, some of
his needs would be met. In the case of a factory or a cow, the production is sold and income
generated. In the case of a motorcar, it provides comfort and convenience in transportation.
There is no direct income. There is normally expected lifetime for the asset during which it is
expected to perform. The owner, aware of this, can so manage his affairs that by the end of that
life time, a substitute is made available to ensure that the value or income is not lost. However, if
the asset gets lost earlier, being destroyed or made non-functional, through an accident or other
unfortunate event, the owner and those deriving benefits there from suffer. Insurance is a
mechanism that helps to reduce such adverse consequences.
Assets are insured, because they are likely to be destroyed or made non-functional, through an
accidental occurrence. Such possible occurrences are called perils. Fire, floods, breakdowns,
lightning, earthquakes etc. are perils. The damage that these perils may cause to the asset is the
risk that the asset is exposed to.
Basics characteristics of insurance are:
3.1.1 Pooling of losses
People have always sought ways to spread risk and protect themselves from loss. Centuries ago,
Chinese merchants divided their cargo among several junks when transporting goods down the
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treacherous Yangtze River. If one of the boats was lost, to the river or to pirates, each merchant
lost just part of the shipment. It was an early method of spreading risk. Arab traders did the same
thing by dividing goods among several caravans.
As civilization progressed, the concept of civic responsibility started to develop. In order to
encourage commerce, a form of insurance called bottomry bonds was developed. They were
called bottomry bonds after bottoms, a name applied to ships in those days. Under such a
bond, the borrower was freed from any obligation if the collateral was lost through no willful act
on the part of the borrower. It was an early form of insurance. The basic protection helped
promote the growth of trade in the ancient world.
3.1.2 Indemnification
One of the important terms of the contractual agreement between the insurance company and the
owner of an insurance policy is the amount of policy benefit that will be payable if a covered loss
occurs. Depending on the way in which a policy states the amount of the policy benefit, every
insurance policy can be classified as either a contract of indemnity or a valued contract. A
contract of indemnity is an insurance policy under which the amount of the policy benefit
payable for a covered loss is based on the actual amount of financial loss that results from the
loss, as determined at the time of loss. The policy states that the amount of the benefit is equal to
the amount of the financial loss or the maximum amount stated in the contract, whichever is less.
When the owner of such a contract submits a claim a request for payment under the terms of
the policy the benefit paid by the insurance company will not be greater than the actual amount
of the financial loss.
Many types of health insurance policies pay a benefit based on the actual cost of a persons
medical expenses and, as such, are contracts of indemnity. For example, assume that Bala Swami
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is insured by a health insurance policy that will pay any covered hospital expenses Bala incurs.
The policy states the maximum amount payable to cover Balas expenses while he is
hospitalized. If he is hospitalized and his actual hospital expenses are less than that maximum
amount, the insurance company will not pay the stated maximum; instead, the insurance
company will pay a sum that is based on the actual amount of Balas hospital bill. Property and
liability insurance policies are also contract of indemnity.
3.1.3 Risk Transfer
Transferring risk is a fourth method of risk management. When you transfer risk to another
party, you are shifting the financially responsibility for that risk to the other party, generally in
exchange for a fee. The most common way for individuals, families and business to transfer risk
is to purchase insurance coverage.
When an insurance company agrees to provide a person or a business with insurance coverage,
the insurer issues an insurance policy. The policy is a written document that contains the terms of
the agreement between the insurance company and the owner of the policy. The agreement is a
legally enforceable contract under which the insurance company agrees to pay a certain amount
of money known as the policy benefit, or the policy proceeds when a specific loss occurs,
provided that the insurer has received a specific amount of money, called the premium.
In general, individuals and business can purchase insurance policies, which covers three types of
risks: property damage risk, liability risk and personal risk.
Insurers that sell insurance policies to provide financial security from property damage risk and
liability risk are known as Property-casualty or property-liability, insurance companies.
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Property insuranceprovides a benefit if the insured items are damaged or lost because
of various specified perils, such as fire, theft or accident.
Liability insuranceprovides a benefit payable on behalf of a covered party who is
legally responsible for unintentionally harming others or their property.
Property insurance or life insurance (also referred to as property and casualty insurance)
are commonly marked together in one policy. Suppose, for example, you are driving a
car that is covered by an automobile property-liability insurance policy and you
accidentally crash through your neighbors front door. The damage to your neighbors
home will be paid by your policys liability coverage; the money to repair your car will
come from your policys property coverage.
Personal insurance; Insurers that sell insurance policies to provide financial security
from personal risk are known as life and health insurance companies. It is the transfer of
personal risk to life and health insurers that we will address in this book. Both
individuals and business purchase life and health insurance policies to provide
themselves with the financial security provided by these products.
3.2 Requirements of Insurable Risks
Insurance products are designed in accordance with some basic principles that define which risks
are insurable. In order for a risk-a potential loss-to be considered insurable, it must have certain
characteristics as follows:
1.) The loss must occur by chance.
2.) The loss must be definite.
3.) The loss must be significant.
4.) The loss rate must be predictable.
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5.) The loss must not be catastrophic to the insurer
These five basic characteristics are used to define an insurable risk form the foundation of the
business of insurance. A potential loss that does not have these characteristics generally is not
considered to be an insurable risk.
1) The loss must occur by chance
In order for a potential loss to be insurable, the element of chance must be present. The
loss should be caused either by an unexpected event or by an event that is not
intentionally caused by the person covered by the insurance. For example, people cannot
generally control whether they will become seriously ill; as a result, insurance
companies can offer health insurance policies to provide economic protection against
financial losses caused by the chance event that the person who is insured will become
ill and incur medical expenses.
When this principle of loss is applied in its strictest sense to life insurance, an apparent
problem arises: death is certain to occur. The timing of an individuals death, however,
is usually out of the individuals control. Therefore, although the event being insured
against-death-is a certain event rather than a chance event, the timing of that event
usually occurs by chance.
2) The loss must be definite
For most types of insurance, an insurable loss must be definite in terms of time and
amount. In other words, the insurer must be able to determine when to pay policy
benefits and how much those benefits should be. Death, illness, disability and old agare
generally identifiable conditions. The amount of economic loss resulting from these
conditions can, however, be subject to interpretation.
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3) The loss must be significant
As described earlier, insignificant losses, like the loss of an umbrella, are not normally
insured. The administrative expenses of paying benefits when a very small loss occurs
would drive the cost for such insurance protection so high in relation to the amount of
the potential loss that most people would find the protection unaffordable
On the other hand, some losses would cause financial hardship to most people and are
considered to be insurable. For example, if a person were to be injured in an accident
that resulted in a long period of disability, he/she would lose a significant amount of
income. Insurance coverage is available to protect against such a potential loss
4) The loss rate must be predictable
In order to provide a specific type of insurance coverage, an insurer must be able to
predict the probable rate of loss that the people insured by the coverage will experience.
To predict the loss rate for a given group of insureds, the insurer must predict the
number and timing of covered losses that will occur in that group of insureds. An
insurer predicts the loss rate for a group of insureds so that it can determine the proper
premium amount to charge each policy owner.
No one can predict the losses that a specific person will experience. We do not know when a
specific person will die, become disabled or need hospitalization. It is possible, however, to
predict with a fairly high degree of accuracy the number of people in a given large group who
will die or become disabled or need hospitalization during a given period of time.
These predictions of future losses are based on the concept that, even though individual events-
such as the death of a particular person-occur randomly, we can use observations of past events
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to determine the likelihood that a given event will occur in the future. This likelihood is called
probability of event. An important concept that is used to determine the probability of an event
occurring is the law of large numbers.
3.3 Advantages and Disadvantages of Insurance in handling risks
Although insurance is only one of the techniques available for dealing with the pure risks that an
individual faces many of the risk management decisions boil down to a choice between insurance
and non-insurance.
Advantages
The following benefits flow out the mechanism of insurance:
A. Indemnification
The direct advantage of insurance is indemnification for unexpected losses.
Organizations/Individuals having the insurance protection, as well as the benefits to the
society by this are obvious.
B. Reduction of Uncertainty
Before purchasing insurance, the potential insured bears the risk associated with possible
losses. As a result, the person is uncertain about the outcome. The insurance transfers
financial consequences of loss to the insurer, who then becomes responsible for
compensating the insured for the loss and providing other loss related services according
to the insurance contract. This is expected to reduce the insureds anxiety and
uncertainty.
C. Funds for Investment
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Insurance premiums are normally payable in advance and held by the insurer till the
time of payment of claims. This enables the insurers to invest these funds, which is
always sizable, and earns attractive returns on the investment made. The returns on the
investments go on to reduce the premium required to be paid for the contract. Though
the individual insured person can also earn returns on their premium amounts, had they
not purchased insurance, the investment expertise available with the insurers, the
opportunities for investing available to the insurers and the size of the investible funds
that the insurer have will make the returns earned by the insurer much more attractive
than what individual can think of. Also, since the Government governs the way the
insurers invest the funds, most of the accumulated funds are invested in the development
of infrastructure of the nation and also the development of capital markets, which is
beneficial to the society as a whole.
D. Loss Control
After insuring the various risks of the organizations, insurance companies take interest
in controlling the losses by providing loss reduction education and advices by trained
experts, which result in lesser losses even in cases where losses have occurred. The
organizations would have had to spend heavily for getting such loss control and loss
minimization expertise if they were not to go in for insurance.
Disadvantages
Although the advantages of purchasing insurance as a tool in management of risks are numerous,
insurance has a few disadvantages also:
a) Operating Expenses
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Insurers incur expenses in loss control measures, in acquisition of insurance business,
claim settlement activities, in risk inspections and rating activities and other general
administrative works. These expenses and a reasonable amount of profit for the insurer
must be charged to the premium payable by the insured. Thus the premium paid by the
insured is more than expected value of losses. The insured pays more than what is his
share in losses that the group is likely to experience because of the expenses listed
above.
b) Moral Hazard
The other disadvantage of insurance mechanism is the moral hazards. Insurance
coverage reduces the insureds incentives to prevent loss or to contain the amount of
damage due to the loss when it occurs. In certain cases, there can be intentional damages
created by the insured themselves, such as arson or staging accidents or hospitalization
when not required etc. in some other cases, there can be attempts to overstate the
damage due to the loss in order to get higher compensation than what would have been
allowed. Thus moral hazard increases the amount of losses experienced by the group in
relation to what would have been in the absence of insurance arrangement. This also
gets provided for in the insurance premium calculations, which the insured persons will
have to pay.
Overall, the advantages that the insurance mechanism provides are much
more than the effects of the disadvantages discussed above, in most of the cases.
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CHAPTER 4: RISK MANAGEMENT PROCESS
4.1 Meaning and Objective of Risk Management
The Rules
Before undertaking risk management planning, the financial planner must equip himself with
certain fundamental knowledge. He must be familiar with the rules of risk management, which
are: 1. Don't risk more than what you can afford to loose.
2. Consider the odds of the risk occurring.
3. Don't risk a lot for little.
Don't risk more than what you can afford to loose
Under this rule, risks that can cause unbearable looses, as well as risks that can only
result in negligible losses, should be identified. For the farmers, steps should be
undertaken to eliminate or reduce the impact of losses.. for example, if the client
becomes permanently and totally disabled due to an illness, he will loose his income
producing capabilities. This can be fatal to the client's survival and he should take up
insurance coverage to provide adequate protection from such unforeseen circumstances.
Consider the odds of the risk occurring
The odds of any loss occurring are another relevant factor to be considered. For
example, if a particular loss is likely to happen, insurance may not be a viable option as
the premiums will probably be too high. Different solutions will have to be adopted in
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such cases. For example, if the client owns a goldsmith shop that is located in a high
crime rate area and has suffered numerous break-ins before, the cost of acquiring theft
insurance will most likely be prohibitive as the chances of another break-in occurring
are very high and the premium will be heavily loaded. As such, the client may have to
consider alternative solutions to manage the risk like relocating the shop to a safer place.
Don't risk a lot for a little
Under this rule, if the cost of carrying out a particular risk management technique is
negligible compared to the potential loss and assuming the potential loss to be large, the
technique should be implemented. For example,, if the client is to purchase a house
made of wood, there is a risk that it might get gutted by fire. The loss sustained in such
an event can be extremely high and if the premium required acquiring adequate fire
insurance coverage is low, the client should, pursuant ti this rule, acquire the fire
insurance coverage.
This rule is also related to the Large Loss principle, which dictates that in
risk management, risks that can result in catastrophic losses should be insured first.
The probability of the loss occurring is of secondary importance in considering whether to
acquire the insurance coverage.
Application of the rules
The three rules of risk management elaborated above should be considered together. Sometimes
application of these rules may result in conflicting conclusions and the financial planner has to
weigh the relevant factors and advise the client accordingly. For example, if a client has a past
history of medical problems, which makes him insurable but at premium rates that are extremely
high, there is a conflict of atleast two principles. Firstly, if no insurance is taken, the occurrence
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of the client's death may result in consequences, which are unbearable to the client and his
family. On the other hand, the cost of insurance is high relative to the benefits. In such a case, the
financial planner has to consider all the relevant factors like affordability, family needs and
family assets before giving his advice.
4.2 The Nature of Risk Management
Risk management is a scientific approach to the problem of dealing with the
pure risk faced by the individuals and business. It is a function of management. The
management of an organization has ultimate responsibility for dealing with all risks facing the
organization, including both pure and speculative risks. Risk management focuses its attention
only on the pure risks.
Risk management deals with insurable and uninsurable risks and the choice of the
appropriate technique for dealing with them. Insurance management includes the use of
techniques other than insurance [e.g. Noninsurance or retention, as an alternative to insurance],
but it is restricted to the area of those risks that are considered to be insurable. Risk management,
in contrast is concerned with all pure risks, regardless of whether they are insurable or not.
The emphasis in risk management is not reducing the cost of handling risk by whatever means
that are considered most appropriate and insurance is viewed as simply one of various
approaches for minimizing the pure risks the firm faces.
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4.3 The Risk Management Process
The risk management process consists of six steps, which are as follows:
A.) Determination of Objectives
The primary objective of the risk management effort is to preserve the operating
effectiveness of the organization, to make sure that it is not prevented from
attaining its other goals by the losses arising from pure risks. This implies
avoidance of financially catastrophic losses that could result in bankruptcy or
that could prevent the organization from performing its functions, whatever those
functions may be. A second objective-equally important in the view of some- is
the humanitarian goal of protecting employees from accidents that might result
in death or serious injury. Other goals may focus on cost, the efficient use of
resources, social responsibility and preservation of good public relations.
B.) Risk Identification
When considering risk identification, as the first step in risk management
process, the basic question would be How can the assets be or earning capacity
of the enterprise be threatened?. The response to this question would bring
about the whole host of ways in which an organization may be impeded from
achieving its objectives.
Risk identification must be recognized as important with in an enterprise and
marked down as a task within the job description of a particular manager, for
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example, the risk manager who is employed to carry out the whole function of
risk management.
The risk management must dig into the operations of the organization and
discover the risks to which it is exposed. He must be armed with the relevant
tools of trade and make use of them. There are a number of important tools or
techniques including insurance policy checklists, risk analysis questionnaire,
analysis of financial statements, hazard and operability studies, physical
inspections of the operations, flow charts and organizational charts which
provide the risk manager with a powerful weapon in the endeavor towards
identifying the risks to which the organization is exposed. But no individual
method or combinations of methods can replace the diligence and imagination of
the risk manager in discovering the risks to which the firm is exposed. Because
risks may lurk in many sources, the risk manager needs a wide-reaching
information system, designed to provide a continual flow of information about
all aspects of the business of the organization and the changes in operations, the
acquisition of new assets and changing relationship with outside entities.
C.) Risk Analysis
Once it has been identified that there is a risk, then steps have to be taken to
measure the potential impact of that risk on the organization. The next step is
therefore in the area of statistical analysis and measurement of risk. In practical
sense, the measurement of risk starts with the gathering of information , followed
by the analysis of past experience, and then move on to look at what data tells us
about the level of severity of risk and its periodicity to which an organization is
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exposed. There is a need for accuracy and relevance at each stage and, above all,
it is necessary to ensure that the results make sense and can be understood.
D.) Risk Assessment
The cost of risk can be looked at from a number of different perspectives. There
is at least the:1. Frequency of risk;
2. Monetary cost or financial severity;
3. Human cost in terms of pain and suffering.
The risk manager must evaluate the risks that are identified. This means
that measuring the potential size of the loss and the probability that it is likely to
occur. The evaluation requires some ranking of priorities. Certain risks, because
of the severity of the possible loss they would entail, will demand attention prior
to others, and in most instances there will be a number of exposures that are
equally demanding. The risk may, therefore, be grouped as critical, important
and unimportant.
Critical risks include all exposures in which the possible losses are of a
magnitude that would result in bankruptcy. There is no doubt that regardless of
how risk is measured, it has had a significant impact on the personal and national
life of many countries. There were a number of incidents, names of which have
become commonplace the world over. e.g. Bhopal, Chernobyl, Kings Cross, the
challenger Space Shuttle, Hillsborough, Mexico City, Exxon Valdez, Manchester
Airport. These were major risks which certainly grabbed headlines when they
occurred. There will be many less serious events and it is this major thrust of risk
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with which the people in the risk and insurance business spend their time.
Important risks include those exposures in which the possible losses would not
lead to bankruptcy, but would require the firm to borrow in order to continue
operations.
Unimportant risks include exposures in which the possible losses couldbe met out of the existing assets or current income of the firm without imposing
undue financial strain.
Assignment of individual exposure to one of these three categories would
depend on financial loss that might result from a given exposure and also the
ability of the firm to absorb such losses. In other words, the size of an
organization would influence the above categorization e.g a risk which is an
important risk to a small organization may be reckoned as unimportant risk by a
large organization.
E.) Implementation of the Decision
The decision for dealing with the risk may be:-1. To retain the risk this may be attained with or without a reserve or fund;
2. To deal with the risk through loss prevention the proper loss preventionprograms must be designed and implemented;
3. To transfer the risk through insurance and this must be followed by theselection of an insurer.
F.) Evaluation And Review
Evaluation and review are essential to the risk management programme
for two reasons. First, the risk management process does not take place in a
vacuum. Things change, new risks arise and old ones disappear. The techniques
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that were appropriate last year may not be most advisable this year, and constant
attention is required. Second, mistakes sometimes occur. Evaluation and review
of the risk management pro grammes permits the manager to review decisions
and discover mistakes hopefully, before they become costly.
Selection of the Risk Treatment Device
Once the risks have been identified and evaluated, the next step is consideration of the
approaches that may be used to deal with risks and the selection of the techniques that should be
used for each one.
Risk management recognizes two broad approaches to dealing with risks facing
an individual or organization: risk control and risk financing.
Risk control focuses on minimizing the risk of loss to which an entity is exposed.
Risk financing concentrates in arranging the availability of funds to meet losses arising from the
risk that remain after the application of risk control techniques. Risk control techniques include
avoidance and reduction of risk, while risk financing involves a choice between retention and
transfer. This means both the chance that something will happen and the severity of the incident,
should it occur.
4.4 Risk Control and Risk Financing
Risk Control
Risk control covers all those measures aimed at avoiding, eliminating or reducing the
chances of loss-producing events occurring, or limiting the severity of losses that do happen.
Here, one is seeking to change the conditions that bring about loss-producing events or increase
their severity. Though some measures call for little more than commonsense, often considerable
technical knowledge is required which is beyond the capabilities of ordinary persons and needs
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expert risk managers in the particular field?
Risk Financing
Here one is concerned with the manner in which those risks that remain after the
risk control measure have been implemented, shall be financed. It has to be recognized that in the
long run an individual/organization will have to pay for its own losses. Therefore the primary
objective of risk financing is to spread more evenly over time, the cost of risks in order to reduce
the financial strain and possible insolvency, which the random occurrence of large losses may
cause. The secondary objective is to minimise the cost of risk. Essentially an organization can
finance its risk costs in the following ways:
1. Payment out of current expenses
2. Through a funded or non-funded reserve
3. By debt or equity financing
4. By pre or post-loss credit
5. By forming a captive, a trust, by pooling or through a spread-loss plan.
The interrelationship of Risk analysis, Risk control and Risk financing is depicted as aflowchart in the next page
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CHAPTER 5: UNDERWRITING OF AN INSURANCE PROPOSAL
5.1 Insurance Market Dynamics and the Underwriting Cycle
Firstly, certain risks may have such a high probability of occurrence that the premium
payable will be too expensive in relation to the benefits offered. For example, some insurers will
issue personal accidents policies only at very high premiums to people working in a highly
combustible environment, for example, in factories that emit explosive gases.
Secondly, the insurer may find it prudent not to insure certain risks. Unless mandated
by law, insurers are free to make such choices.
Generally, for a risk to be insurable, the following four characteristics must be present:
1. There must be a sufficiently large number of homogeneous exposure units to make thelosses reasonably predictable.
2. The loss produced by the risk must be definite and measurable.
3. The loss must be fortuitous or accidental.
4. The loss must not be catastrophic.
5.2 Underwriting definition and guidelines
Definition:
Insurance involves the sharing of loss due to exposure to a common peril. All insured parties
make contributions to a common fund from which payment of an agreed sum can be made to
members who are victims of the peril. For the payment of the contributions (premiums) to be
equitable, the sum must be commensurate with the risk that the paying member adds to the
insurable pool.
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Underwriting is a process of selection and classification of risk exposures to determine
the extent of contribution payable by any particular individual who wish to be member. The goal
of underwriting is not the selection of risks that will not result in losses; rather, it is to avoid a
disproportionate amount of bad risks, in addition, an underwriter has to gain a sufficient number
of exposure units in each class.
Guidelines:
The underwriting process aims to establish a schedule or premiums for each class of risk.
In the area of life insurance for example, it is usually subject to the following principles:
a. Standard category to be the main class
For the insurance concept to be viable, the main class should be those in the
standard category, namely, the category consisting of those exposed to an
average level of risk. This is especially important for insurers who do not insure
those in the sub-standard category.
By establishing the standard class to include a predominant group of insured, the
morale of the agency force can be maintained; the cost of business can be
controlled, public goodwill can be preserved and the group will be more stable.
b. Balance within each risk classification
To ensure stability within each risk classification, each class covers risks that
deviate from the class average to a specified extent. The margin of risk allowed
to exceed the average in each class should, approximately, not be more than the
margin allowed for the below average risks in order to control the extent of
mortality expenses.
c. Equity among policyholders
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For an insurance program to be sustainable, the policyholders obligations and
benefits must be equitable vis--vis those of other policyholders. It is not
possible to ensure total equity among policyholders in view of diversity and
variety of cases. However, the program must attain a certain minimum level of
fairness to ensure that no one is unduly discriminated against or favored.
d. Based on relevant mortality assumptions
The underwriting process must ensure that the mortality expenses are in line with
the underlying mortality assumption. If the mortality expenses are excessive
compared to the assumptions, the common fund may be depleted.
e. System to ensure underwriting efficacy of underwriting process
The insurer must be capable of ascertaining that, during the process of being
insured, the risks remain insurable and that adverse selection is minimized. To do
so, most insurers set up the following mechanisms:
Firstly, the insurer creates risk categories and establishes underwriting
guidelines.
Secondly, the insurer will instruct the insurance agent to be field underwriters
who are to filter off unsuitable risks.
Thirdly, the insurers will set up a panel of qualified underwriters to rigorously
apply to guidelines.
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5.3 Life Insurance Underwriting
In life insurance underwriting, several factors are normally taken in to account to assess the level
of risk faced by a prospect. They are:
Age
Except for the first few years of life , the risk of death and injuries faced by a person
increases with age resulting in the increase of premiums payable.
Build
The relationship between the prospects height, weight and girth is an important
indicator of the health of a person and will thus affect his mortality. If the relationship is
not within certain acceptable ranges, this may indicate that the person is more
susceptible to illness or death and as a result, his premium will be higher. For example, a
significantly obess person may run a higher risk of diabetes or heart disease, and for
insurance to be equitable to all policyholders; the person may have to pay a higher
premium.
Physical Condition
If the prospect has any physical condition that affects his life expectancy, his premium
will also have to be adjusted. Examples are heart valve defect or mental defect.
Personal History
Information on the prospects personal history like his health record, past habits and
surroundings, previous occupation and insurance are relevant to the underwriter and can
help determine the prospects life expectancy.
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Family History
The prospects family history is important as it enables the underwriter to discover any
hereditary defects or illness, which may be found in the family. This may affect the life
expectancy of the prospect. For example, if a persons parents and/or siblings have
suffered from colon cancer before, there is a higher of the disease striking him as well.
Residence
The persons place to stay can be a relevant factor in assessing his life expectancy. It can
be argued, all other things being equal, that a person living in a diseased and violence
ridden country is more likely to have a lower life expectancy than one who lives in a
developed and secure place.
Habits
These habits refer to the taking of drugs or the consumption of alcohol. A drug addict or
an alcoholic is unlikely to be insurable and prospect are normally required to declare any
involvement with these substances for the underwriters consideration.
Occupation
The nature of prospects occupation is also a necessary factor to be considered by the
underwriter. If the prospect works in a place that is accident prone, dangerous or filled
with toxic particles, his life expectancy will be affected for the worse and a higher
premium will be imposed on him. If the occupation requires him to perform dangerous
and life threatening tasks, again the premium is likely to increase substantially. In fact,
in certain cases, the prospect may be uninsurable because of his occupation.
Morals
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A persons sense of mortality is reflected in his conduct. The underwriter would desire
in their prospect a minimum level of morality before agreeing to insure him. If the
person happens to have an unsavory reputation, the insurer will be very careful about
insuring him, as the information provided by the prospect in the application form may be
false or contains serious omissions.
Sex
All things being equal, the premium for the female is usually lower than that of a male
because statistics have shown that they have longer life expectancy than the males.
The nature of the insurance plan
The strictness of underwriting standards also depends on the type of the insurance
policy. The gauge is the amount of risk found in the policy. The amount of risk in a
policy refers to the extent of the insurers exposure under the policy. For example, in
underwriting a single premium policy, the underwriter is usually more lenient as the
lump sum payment would have minimised the insurers risk exposure.
Avocation
Certain avocations taken up by the prospects will result in a higher premium. Examples
of such avocations are deep sea diving, speedboat racing, mountain climbing or
motorcar racing.
Economic Status
Under the principles of insurance laws, there is no limit to the value of a human life and
a person can take up as much insurance coverage as he wants to. However, in practice,
insurers do not want to provide coverage to an insured beyond a level deemed
acceptable.
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The law does not prohibit the insurer from exercising its discretion in limiting the
insurance coverage of any particular person. Most insurers will provide coverage up to
an amount deemed suitable in relation to the insureds economic means. This will
prevent over-insurance and also ensure a higher chance of the insured being faithful in
the payment of premiums.
Military Service
If the prospect is undergoing military service at a war front, the insurer may be unlikely
to provide coverage for the soldier but in India, the life insurance cover is available for
service personnel in army/Navy/Air Force.
5.4 Sources of Underwriting Information
The underwriter has an important role to study and assess all relevant information available from
the following sources:
Agent
The insurance agent or broker is normally appointed as the field underwriter. He is
usually given precise information as to what types of risks are deemed acceptable to the
insurer.
He is usually required to submit a report containing relevant information about the
insured. As he is only representative from the insurer to see and speak to the prospect, he
is expected to report any instances of false representations. For example, if the prospect
is blind but omits to declare this in the application form, the agent has a duty to inform
the insurer about this.
The Applicant
A substantial amount of information is supplied by the applicant by way of completion
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of an application form.
Medical Sources
The insurer may also send the applicant for the relevant medical examinations and tests
or apply for an attending physicians report to ascertain the health of the applicant.
5.5 Methods of Underwriting
Life insurers nowadays resort to two methods of underwriting, namely:
1. The Judgment Method; and
2. The Numerical Rating System
The Judgment Method
Under this method, regular and routine applications are managed by the clerical staff.
The more difficult or borderline cases will be referred to senior supervisors for their
assessment. These supervisors normally have a wealth of experience to tap on and their
impression of the case is crucial to the outcome. The judgment method is normally
suitable in cases where there is only one unfavorable factor or the only decision
applicable is either to accept or decline the case.
The Numerical Rating System
This method is based on the premise that a large number of factors determine the nature
of the risk. An insured with an average risk is given a 100% rating. Any adverse factor
will increase the rating by an amount related to the seriousness of the adverse factor
while a favorable factor will reduce the rating by an amount related to the extent of
favorability of the factor involved.
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Underwriting Guidelines Followed by ICICI Prudential LifeInsurance Company
Financial Underwriting
While accepting the proposals, care should be taken. The cases of over insuranceshould be
avoided, as the risk cannot be covered by charging some extra premium (as in the case of
medical risk) and the probability of lapse of policy will be very high.
Financial Underwriting evaluates the following:
1. Ability of the consumer to pay premiums, so that the persistency is maintained,because lapsation is an unfavorable situation for both the customer and company.
2. Whether the income is in the proportion of the life cover proposed by the customer.
The following table indicates the maximum sum at risk that can be extended to an individual.
Age (years) Total Sum Assured (death risk) to be restricted
to no. of times of gross annual income
Up to 35 20 times
36 40 15 times
41 45 12 times
46 50 10 times
51 60 5 times
Above 60 On Merits
Note:
When the sum at risk is above 15 lakhs, one has to submit an income proof.
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For people not earning income, factors determining insurance depends on the education,
profile and insurance covers of individuals they are dependent on.
Eg: Students, Housewives.
Acceptable Income Documents
Income Document: Shows