BBA 5th SEM Banking and Insurance Unit :1

UNIT 1: Risk and Insurance: Definig risk, Nature and types of risk, risk management
process,Risk and its relation with Insurance.Concept and significance of
Insurance,classification of life and non-life Insurance.General principles of Insurance

Risk implies the extend to which any chosen action or an inaction that may lead to a loss or
some unwanted outcome. The notion implies that a choice may have an influence on the
outcome that exists or has existed.

However, in financial management, risk relates to any material loss attached to the project that
may affect the productivity, tenure, legal issues, etc. of the project.

In finance, different types of risk can be classified under two main groups, viz.,

Systematic risk.

Unsystematic risk.

The meaning of systematic and unsystematic risk in finance:

Systematic risk is uncontrollable by an organization and macro in nature.

Unsystematic risk is controllable by an organization and micro in nature.

A. Systematic Risk

Systematic risk is due to the influence of external factors on an organization. Such factors are
normally uncontrollable from an organization's point of view.

It is a macro in nature as it affects a large number of organizations operating under a similar

stream or same domain. It cannot be planned by the organization.

The types of systematic risk are depicted and listed below.

Interest rate risk,

Market risk and

Purchasing power or inflationary risk.

1. Interest rate risk

Interest-rate risk arises due to variability in the interest rates from time to time. It particularly
affects debt securities as they carry the fixed rate of interest.
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The types of interest-rate risk are depicted and listed below.

Price risk and

Reinvestment rate risk.

The meaning of price and reinvestment rate risk is as follows:

Price risk arises due to the possibility that the price of the shares, commodity, investment, etc.
may decline or fall in the future.

Reinvestment rate risk results from fact that the interest or dividend earned from an
investment can't be reinvested with the same rate of return as it was acquiring earlier.

2. Market risk

Market risk is associated with consistent fluctuations seen in the trading price of any particular
shares or securities. That is, it arises due to rise or fall in the trading price of listed shares or
securities in the stock market.

The types of market risk are depicted and listed below.

Absolute risk,

Relative risk,

Directional risk,

Non-directional risk,

Basis risk and

Volatility risk.

The meaning of different types of market risk is as follows:

Absolute risk is without any content. For e.g., if a coin is tossed, there is fifty percentage chance
of getting a head and vice-versa.

Relative risk is the assessment or evaluation of risk at different levels of business functions. For
e.g. a relative-risk from a foreign exchange fluctuation may be higher if the maximum sales
accounted by an organization are of export sales.

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Directional risks are those risks where the loss arises from an exposure to the particular assets
of a market. For e.g. an investor holding some shares experience a loss when the market price
of those shares falls down.

Non-Directional risk arises where the method of trading is not consistently followed by the
trader. For e.g. the dealer will buy and sell the share simultaneously to mitigate the risk

Basis risk is due to the possibility of loss arising from imperfectly matched risks. For e.g. the
risks which are in offsetting positions in two related but non-identical markets.

Volatility risk is of a change in the price of securities as a result of changes in the volatility of a
risk-factor. For e.g. it applies to the portfolios of derivative instruments, where the volatility of
its underlying is a major influence of prices.

3. Purchasing power or inflationary risk

Purchasing power risk is also known as inflation risk. It is so, since it emanates (originates) from
the fact that it affects a purchasing power adversely. It is not desirable to invest in securities
during an inflationary period.

The types of power or inflationary risk are depicted and listed below.

Demand inflation risk and

Cost inflation risk.

The meaning of demand and cost inflation risk is as follows:

Demand inflation risk arises due to increase in price, which result from an excess of demand
over supply. It occurs when supply fails to cope with the demand and hence cannot expand
anymore. In other words, demand inflation occurs when production factors are under
maximum utilization.

Cost inflation risk arises due to sustained increase in the prices of goods and services. It is
actually caused by higher production cost. A high cost of production inflates the final price of
finished goods consumed by people.

B. Unsystematic Risk

Unsystematic risk is due to the influence of internal factors prevailing within an organization.
Such factors are normally controllable from an organization's point of view.

It is a micro in nature as it affects only a particular organization. It can be planned, so that

necessary actions can be taken by the organization to mitigate (reduce the effect of) the risk.
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The types of unsystematic risk are depicted and listed below.

Business or liquidity risk,

Financial or credit risk and

Operational risk.

Now let's discuss each risk classified under this group.

1. Business or liquidity risk

Business risk is also known as liquidity risk. It is so, since it emanates (originates) from the sale
and purchase of securities affected by business cycles, technological changes, etc.

The types of business or liquidity risk are depicted and listed below.

business risk

Asset liquidity risk and

Funding liquidity risk.

The meaning of asset and funding liquidity risk is as follows:

Asset liquidity risk is due to losses arising from an inability to sell or pledge assets at, or near,
their carrying value when needed. For e.g. assets sold at a lesser value than their book value.

Funding liquidity risk exists for not having an access to the sufficient-funds to make a payment
on time. For e.g. when commitments made to customers are not fulfilled as discussed in the
SLA (service level agreements).

2. Financial or credit risk

Financial risk is also known as credit risk. It arises due to change in the capital structure of the
organization. The capital structure mainly comprises of three ways by which funds are sourced
for the projects. These are as follows:

Owned funds. For e.g. share capital.

Borrowed funds. For e.g. loan funds.

Retained earnings. For e.g. reserve and surplus.

The types of financial or credit risk are depicted and listed below.
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credit risk

Exchange rate risk,

Recovery rate risk,

Credit event risk,

Non-Directional risk,

Sovereign risk and

Settlement risk.

The meaning of types of financial or credit risk is as follows:

Exchange rate risk is also called as exposure rate risk. It is a form of financial risk that arises
from a potential change seen in the exchange rate of one country's currency in relation to
another country's currency and vice-versa. For e.g. investors or businesses face it either when
they have assets or operations across national borders, or if they have loans or borrowings in a
foreign currency.

Recovery rate risk is an often neglected aspect of a credit-risk analysis. The recovery rate is
normally needed to be evaluated. For e.g. the expected recovery rate of the funds tendered
(given) as a loan to the customers by banks, non-banking financial companies (NBFC), etc.

Sovereign risk is associated with the government. Here, a government is unable to meet its loan
obligations, reneging (to break a promise) on loans it guarantees, etc.

Settlement risk exists when counterparty does not deliver a security or its value in cash as per
the agreement of trade or business.

3. Operational risk

Operational risks are the business process risks failing due to human errors. This risk will change
from industry to industry. It occurs due to breakdowns in the internal procedures, people,
policies and systems.

The Risk Management Process

Risk Management is defined in the standard (AS/NZS 4360:2004) as "the systematic application
of management policies, procedures and practices to the tasks of establishing the context,
identifying, analysing, assessing, treating, monitoring and communicating".

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It is an iterative process that, with each cycle, can contribute progressively to organisational
improvement by providing management with a greater insight into risks and their impact.

Risk management can be applied to all levels of an organisation, in both the strategic and
operational contexts, to specific projects, decisions and recognised risk areas.

Risk is defined as 'the chance of something happening that will have an impact on objectives'. It
is, therefore, important to understand what the objectives of the University, Faculty, work unit
or your position, are, prior to attempting to analyse the risks.

Risk analysis is best done in a group with each member of the group having a good
understanding of the tasks and objectives of the area being analysed.

1. Identify the Risks: as a group, list the things that might inhibit your ability to meet your
objectives. You can even look at the things that would actually enhance your ability to meet
those objectives eg. a fund-raising commercial opportunity. These are the risks that you face eg.
loss of a key team member; prolonged IT network outage; delayed provision of important
information by another work unit/individual; failure to seize a commercial opportunity etc.

2. Identify the Causes: try to identify what might cause these things to occur eg. the key team
member might be disillusioned with his/her position, might be head hunted to go elsewhere;
the person upon whom you are relying for information might be very busy, going on leave or
notoriously slow in supplying such data; the supervisor required to approve the commercial
undertaking might be risk averse and need extra convincing before taking the risk etc etc.

3. Identify the Controls: identify all the things (Controls) that you have in place that are aimed
at reducing the Likelihood of your risks from happening in the first place and, if they do happen,
what you have in place to reduce their impact (Consequence) eg. providing a friendly work
environment for your team; multi-skill across the team to reduce the reliance on one person;
stress the need for the required information to be supplied in a timely manner; send a reminder
before the deadline; provide additional information to the supervisor before he/she asks for it
etc.

4. Establish your Likelihood and Consequence Descriptors, remembering that these depend
upon the context of your analysis ie. if your analysis relates to your work unit, any financial loss
or loss of a key staff member, for example, will have a greater impact on that work unit than it
will have on the University as a whole so those descriptors used for the whole-of-University
(strategic) context will generally not be appropriate for the Faculty, other work unit or the

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individual eg. a loss of $300000 might be considered Insignificant to the University, but it could
very well be Catastrophic to your work unit.

5. Establish your Risk Rating Descriptors: ie. what is meant by a Low, Moderate, High or
Extreme Risk needs to be decided upon ahead of time. Because these are more generic in
terminology though, you might find that the University's Strategic Risk Rating Descriptors are
applicable.

6. Add other Controls: generally speaking, any risk that is rated as High or Extreme should have
additional controls applied to it in order to reduce it to an acceptable level. What the
appropriate additional controls might be, whether they can be afforded, what priority might be
placed on them etc etc is something for the group to determine in consultation with the Head
of the work unit who, ideally, should be a member of the group doing the analysis in the first
place.

7. Make a Decision: once the above process is complete, if there are still some risks that are
rated as High or Extreme, a decision has to be made as to whether the activity will go ahead.
There will be occasions when the risks are higher than preferred but there may be nothing
more that can be done to mitigate that risk ie. they are out of the control of the work unit but
the activity must still be carried out. In such situations, monitoring the circumstances and
regular review is essential.

8. Monitor and Review: the monitoring of all risks and regular review of the unit's risk profile is
an essential element for a successful risk management program.

Risk is the exposure to uncertainty. An insurance policy is an exchange of a certain loss (the
premium) to have another party (the insurer) absorb all or part of the negative consequence of
being exposed to that uncertainty.

For example, you have virtually no risk of dying in an airplane crash if you do not get in an
airplane. You are not exposed, other than that a plane could fall on you. Likewise, if you jump
out of an airplane without a parachute, there is no risk. You have all the exposure in the world,
but it is certain that you will be killed. There may be some trivial risk that you live but it is so
small that it can be ignored.

You need two things, uncertainty and exposure. Life insurance is a good example, you know for
certain that you will die, you do not know when. The insurer covers you against premature
death. Its reverse, the immediate annuity, covers you against living too long and running out of
investment resources.

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MEANING OF INSURANCE:

A promise of compensation for specific potential future losses in exchange for

a periodic payment. Insurance is designed to protect the financial well-being of an
individual, company or other entity in the case of unexpected loss. Some forms of insurance are
required by law, while others are optional. Agreeing to the terms of an insurance policy creates
a contractbetween the insured and the insurer. In exchange for payments from the insured
(called premiums), the insurer agrees to pay the policy holder a sum of money upon the
occurrence of a specific event. In most cases, the policy holder pays part of the loss (called
the deductible), and the insurer pays the rest. Examples include car insurance, health
insurance,disability insurance, life insurance, and business insurance.

Importance of insurance

The contributions of insurance to business community and human life are the significant.

Importance of insurance can be understand by the following facts.

 Reasonable profit

The businessmen can earn a reasonable profit for their businesses. The insurance can help
them to earn the same rate of profit if their business fails to generate income.

 Sense of security

There are many chances of losses in a business. But due to insurance, the risk of losses is
transferred to insurance company and it gives the sense of security to businessman.

 Employment increase

The insurance companies provided the jobs to thousands of people. In this way the problem of
unemployment is reduced.

 Protection of property

Due to insurance the personal and business property is protected from natural losses such as
accident, fire, etc.

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 Solve the social problem

Insurance is useful device for solving the social problems. In cash of death provides finance to
his family compensation is available to overcome the industrial injuries and road accident.

 Favourable balance of payment

The insurance of business is an invisible export and it provides sufficient contribution toward
the balance of payment

 Equitable premium

The large policy holders provide large funds and small policy holders pay less money in common
funds. In the way the amount of premium becomes equitable.

 Research facilities

The insurance companies can conduct research about the rate of accidents, death and losses
faced by business units.

 Low price

The risk of loss is covered by the insurance policy. In the way insurance companies help the
business to sell their products as low prices.

 Spread of risk

A large number of persons get marine, fire, life insurance policies and pay premiums to the
insurance companies whenever a loss occurs, it is compensated out of the funds of the insurers.
The loss is spread among a large number of policy holders.

 Promotes economic growth

Insurance contributes to the efficiency of the business and promotes economic growth and
development.

 Gives sense of security

At every moment there is a chance of loss in business. Due to insurance risk is a transferred to
the insurance company and gives the sense of security to businessman.
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 Promotes business competition

Insurance also protects the small industrial units and also provides credit facility. So
competition with the big firms increase which is very useful the customer.

 Promotes international trade

Insurance companies are playing very effective role in promoting the growth of international
trade. Today one exporter can send his goods to other country without a fear of damage or
loss. Because he shifts his risk to insurance company by paying the premium, If ship damage,
insurance company will compensate the loss.

Types of Insurance

Insurance, which is based on a contract, may be broadly classified into the following types.

(i) Life Insurance

(ii) Fire Insurance

(iii)Marine Insurance, and

(iv)Other types such as burglary insurance, motor vehicle insurance, etc.

Until recently Life Insurance Corporation of India (LIC) and General Insurance Corporation

with its subsidiaries happened to be the only organizations engaged in life and general
insurance

business in India. Now a number of other private companies have entered this service sector.

(i) Life Insurance

A contract of life insurance (also known as ‘life assurance’) is a contract whereby the insurer
undertakes to pay a certain sum either on the death of the insured or on the expiry of a certain
number of years. In return, the insured agrees to pay an amount as premium either in a lump
sum or in periodical instalments, annually or half-yearly. The risk insured against in this case is
certain to happen. Hence, life insurance is also referred to as life assurance. The written form of
contract is known as life insurance policy. It provides for the payment of a fixed sum to the
insured either on a fixed date or on the happening of an event, which is certain. Businessmen
can provide for life insurance of all their employees by way of group insurance. It also develops
loyalty among employees and can be used as a security for raising loans.

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There are two basic types of life assurance policies (a) Whole-life policy, and (b) Endowment
Policy. A whole life policy runs for the whole life of the insured and premium is payable all
along.

The sum assured becomes due for payment to the heirs of the insured only after his death. An
endowment policy on the other hand, runs for a limited period or upto a certain age of the
insured. The sum assured becomes due for payment at the end of the specified period or on
the death of the insured, if it occurs earlier.

(ii) Fire Insurance

A contract of fire insurance is a contract whereby the insurer, on payment of premium by the
insured, undertakes to compensate the insured for the loss or damage suffered by reason of
certain defined subject matter being damaged or destroyed by fire. It is a contract of indemnity,
that is, the insured cannot claim anything more than the value of property lost or damaged by
fire or the amount of policy, whichever is lower. The claim for loss by fire is payable subject to
two conditions, viz; (a) there must have been actual fire; and (b) fire must have been accidental,
not intentional; the cause of fire being immaterial. The basic principle applied with regard to
claim is the principle of indemnity. The insured is entitled to be compensated for the amount of
actual loss suffered subject to a maximum amount for which he had taken the policy. He cannot
make a profit through insurance. For example, if a person takes a fire insurance policy of Rs.
20,000/- on certain goods. Out of these, goods worth Rs. 15,000/- are destroyed by fire. The
insured can only claim an amount to the extent of loss i.e., Rs. 15,000/- (and not Rs. 20, 000/-)
for the damage from the insurance company.

(iii) Marine Insurance

Marine insurance is an agreement (contract) by which the insurance company (also known as

underwriter) agrees to indemnify the owner of a ship or cargo against risks, which are
incidental to marine adventures. It also includes insurance of the risk of loss of freight due on
the cargo.

Marine insurance that covers the risk of loss of cargo by storm known as cargo insurance. The
risk of loss of freight if the cargo is damaged or lost. Such a marine insurance is known as freight

insurance. All marine insurance contracts are contracts of indemnity.

(iv) Other types of Insurance

Apart from life, fire and marine insurance, general insurance companies can insure a variety of

other risks through different policies. Some of these risks and the different policies are outlined
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below.

(a) Motor vehicles Insurance: Insurance of all types of motor vehicles- passenger cars,

vans, commercial vehicles, motor cycles, scooters, etc., covers the risks of damage of the

vehicle by accident or loss by theft, as also risks of liability arising out of injury or death of

third party involved in an accident. Third party risk insurance is compulsory under the

Motor Vehicles Act.

(b) Burglary Insurance: Under this insurance the insurance company undertakes to indemnify

the insured against losses from burglary i.e., loss of moveable goods by robbery and theft

by breaking the house.

(c) Fidelity Insurance: As a protection against the risks of loss on account of embezzlement

or defalcation of cash or misappropriation of goods by employees, businessmen may get

policies issued covering the risks of loss on account of fraud and dishonesty on the part of

employees handling cash or in charge of stores. This is called fidelity insurance policy. The

employees may also be required to sign a fidelity guarantee Bond.

Principles of Insurance

There are certain principles that may apply to the contracts of insurance between insurer and

insured, which are as follows.

i. Utmost goods faith

Insurance contracts are the contract of mutual trust and confidence. Both parties to the

contract i.e., the insurer and the insured must disclose all relevant information to each other.

For example, while entering into a contract of life insurance, the insured must declare to the

insurance company if he is suffering from any disease that may be life threatening.

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ii. Insurable interest

It means financial or pecuniary interest in the subject matter of insurance. A person has

insurable interest in the property or life insured if he stands to gain from its existence or

loose financially from its damage or destruction. In case of life insurance, a person taking

the policy must have insurable interest at the time of taking the policy. For example, a man

can take life insurance policy on the name of his wife and if later they get divorced this will

not affect the insurance contract because the man had insurable interest in the life of his wife

at the time of entering into the contract.

In case of marine insurance insurable interest must exist at the time of loss or damage to the

property. In contract of fire insurance, it must exist both at the time of taking the policy as

well as at the time of loss or damage to the property.

iii. Indemnity

The word indemnity means to restore someone to the same position that he/she was in

before the event concerned took place. This principle is applicable to the fire and marine

insurance. It is not applicable to life insurance, because the loss of life cannot be restored.

The purpose of this principle is that the insured is not allowed to make any profit from the

insurance contract on the happening of the event that is insured against. Compensation is

paid on the basis of amount of actual loss or the sum insured, which ever is less.

iv. Contribution

The same subject matter may be insured with more than one insurer. In such a case, the

insurance claim to be paid to the insured must be shared or contributed by all insurers.

v. Subrogation

In the contract of insurance subrogation means that after the insurer has compensated the

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insured, the insurer gets all the rights of the insured with regard to the subject matter of the

insurance. For example, suppose goods worth Rs. 20,000/- are partially destroyed by fire

and the insurance company pays the compensation to the insured, then the insurance

company can take even these partially destroyed goods and sell them in the market.

vi. Mitigation

In case of a mishap the insured must take all possible steps to reduce or mitigate the loss or

damage to the subject matter of insurance. This principle ensures that the insured does not

become negligent about the safety of the subject matter after taking an insurance policy.

The insured is expected to act in a manner as if the subject matter has not been insured.

vii. Causa-proxima (nearest cause)

According to this principle the insured can claim compensation for a loss only if it caused by

the risk insured against. The risk insured should be nearest cause (not a remote cause) for

the loss. Then only the insurance company is liable to pay the compensation. For example

a ship carrying orange was insured against losses arising form accident. The ship reached

the port safely and there was a delay in unloading the oranges from the ship. As a result the

oranges got spoilt. The insurer did not pay any compensation for the loss because the

proximate cause of loss was delay in unloading and not any accident during voyage.

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