Risk

Part I- Module 1 Risk & Insurance

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What is Risk & Types of Risk
 What is Risk????
• Results not as per expectation-here returns
• Unexpected negative phenomenon or
• Expected positive phenomenon not
happening
 Types of Risk
• Systematic risk-non diversifiable-is one which
effects on the market as a whole-inflation
,political ,monsoon vagaries.
• Unsystematic risk-diversifiable-individual
business, new technology, management
expertise, capital structure. line of business
activity.
 Types of risks
• Capital risk
• Interest rate risk
• Liquidity risk
• Credit risk
• Inflation risk
• Currency risk
• Risk of not taking risk
• Country risk
Types of Investment Risks

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 Risk
• Total risk = General risk + Specific risk
     = Market risk + Issuer risk
      = Systematic risk
+ Nonsystematic risk

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Degree of Risk
• Every investor needs to find his or her comfort level with risk and
construct an investment strategy, with the help of a financial planner,
around that level.
• There is no “right or wrong” amount of risk – it is a very personal decision
for each investor.
• However, young investors can afford higher risk than older investors can
because young investors have more time to recover if disaster strikes.
• If an investor is five years away from retirement, he probably would not
want to be taking extraordinary risks with his nest egg, because he will
have little time left to recover from a significant loss.
• However, a too conservative approach may mean the investor will not
achieve his financial goals.
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Standard Deviation
• Standard deviation or variance is used to calculate the total risk
associated with the expected return
• This is a measure of the spread or dispersion in the probability
distribution; that is, a measurement of the dispersion of a random
variable around its mean.
• The larger this dispersion, the larger the variance or standard deviation.
• Also, the larger the standard deviation, the more uncertain the outcome.
• Standard deviation is square root of variance, where variance = Sum of
{Probabilities*(actual return-expected return)2}.
• The standard deviation of return measures the total risk of one security
or the total risk of a portfolio of securities.

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 Risk of a portfolio
• In a portfolio of different securities-returns
would depend on return on individual
securities as well as weightage of each
security
• It can be calculated by considering the sd of
individual securities as well as interactive risk
among securities, measured by covariance
 Covariance
• Is a Measure whether 2 set of returns (securities)
move together or opposite direction.The statistical
measure of co-variance is correlation coefficient.
• Assets which move in exactly opposite direction all
the time are said to be perfectly –vely correlated &
have correlation coefficient of -1
• Same direction +1 & no relation 0..helps in asset
allocation. putting money in –ve correlated sectors.
 Beta
• Beta is the measure of sensitivity of a stock-
security in relation to market-benchmark.
• It could be less than or more than one.
• Beta is the market risk of a security.
 Expected Returns
Assuming equal probability, and with closing pricing of a stock for the previous years calculate
the expected price of the stock for the current year..
• Stock A
– Year 0 : Rs 100
– Year 1 : Rs 120
– Year 2 : Rs 80
– Year 3 : Rs 110
– Year 4 : Rs 100
– Year 5 : ?
• Stock B
– Year 0 : Rs 100
– Year 1 : Rs 90
– Year 2 : Rs 120
– Year 3 : Rs 110
– Year 4 : Rs 100
– Year 5 : ?

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Expected returns – Use XL to calculate

Probability A B

0.2 100 100

0.2 120 90

0.2 80 120

0.2 110 110

0.2 100 100

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 Which Stock?
• Risk & Return For Stock A
• Risk & Return For Stock B

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Stock which has less variation from
the expected price, because we
want to be sure that we get closer
to what we want

We use standard deviation to find which

stock varies less from the expected return..
Meaning which stock is less risky..

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 Standard deviation
• Variance= Sum { Probability * (actual return –
expected return)2 }
• Standard deviation = sq root of variance

• Higher Standard Deviation means higher risk

and Lower SD = Lower Risk against its average

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Work out the standard deviation?

Probability Returns

0.2 15%

0.3 18%

0.3 10%

0.2 8%
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 SD – solution (Use-XL to calculate)

Returns Actual Differenc Probabili Diff

returns – e ty sq*proba
exp squared bility
returns
15 2 4 0.2 0.8

18 5 25 0.3 7.5

10 -3 9 0.3 2.7

8 -5 25 0.2 5
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 S. D. Solution
• The sum of the last column is 16 which is the
variance
• Square root of variance is standard deviation =
4
• Standard deviation in this case is 4%
• The lower the standard deviation the better
are the chances of getting the expected
returns

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 Expected return - portfolio
• Let’s consider a portfolio with two securities A
and B with a weight of 60% assigned to A and
40% to security B. If the following are the
probabilities of return for individual securities
A and B let us try and find out the probable
return on the portfolio:

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 Expected return - portfolio
Probability Probable return Probable return
on security A on security B
0.15 25% 30%

0.2 15% 20%

0.3 0 5%

0.2 -5% 0

0.15 -10% -10%

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Risk Management

Avoidance
Reduction
Retention
Transfer
 WHAT INFLUENCE RISK – TIME

• The objectives being pursued may require a policy statement that speaks to
specific planning horizons.
• In the case of an individual investor this could be a year or two in anticipation of a
down payment on a home purchase or a lifetime, if planning for retirement.
• Generally speaking, the longer the time horizon, the more risk can be
incorporated into the financial planning.
• A financial planner has to take into account the time horizon while structuring
investment portfolios and the general rule is younger a person is, longer can be
his time horizon, and hence more exposure to equities.
• Time has a different effect when analyzing the risk of owning fixed income
securities, such as bonds.
• There is more risk associated with holding a bond long term than short term
because of the uncertainty of future inflation and interest rate levels.

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 Risk Management
DIVERSIFICATION
• Most common tool for risk management is
diversification .Diversification can be
• Risk Reduction through Product Diversification
( ASSET ALLOCATION)
– Across-asset class-debt, equity ,real estate and
various alternative asset class
– Across –geographies- BRIC, USA , UK
– Across different industries & securities-stocks
• Risk Reduction through Time Diversification
( SIP)
 Time diversification
• Generally speaking longer the time frame longer risk
can be incorporated in a portfolio or plan- younger a
person more exposure to equities
• Rupee cost averaging.
• Time has diff effect when analyzing the risk of
owning fixed income securities-there is more risk in
holding bonds for longer term bcos of uncertainty of
inflation & Interest rates.
 Risk Management
• Risk Avoidance
• Risk avoidance is accomplished by not
engaging in the action that gives rise to risk.
Avoiding risk is an
• Appropriate strategy for high frequency and
high severity risks.
 Risk Management
Risk Retention
• Risk retention is used when the risk is retained. The
retention may be voluntary or involuntary.
• Appropriate strategy for low frequency and low
severity risks. For example, the risk of suffering from
common cold can be retained. As a general rule, risks
that should be retained are those that lead to
relatively small certain losses.
• The reason for retention is because there is a cost
attached to transfering,reducing or avoiding risk. It
may be more cost effective to retain the risk since its
frequency as well as impact is low.
 Risk Management
Risk Transfer
• Risk transfer is the transfer of risk from one
individual to another who is more willing to
bear the risk.
• Insurance is the most widely used means for
reducing risk by transfer. Risk transfer is
appropriate for low frequency and high
severity risks. 
 Risk & Insurance

Part II- Introduction to Insurance

 Strategies to Manage Risk
• High Frequency and High Severity – Avoidance
• High Frequency and Low Severity-
Reduction( taking measures of control
/precaution)
• Low Frequency and Low Severity – Retention
• Low Frequency and High Severity - Transfer
 Risk & Insurance- Transfer of Risk
• Risk is the possibility of harm, injury, loss,
danger, or destruction.
• What causes risk – Perils & Hazards
– Peril is one cause of a loss. We refer to the peril of
Fire, Burglary
– A Hazard, on the other hand is a condition that
may create or increase the chance of loss – arising
out of the given peril.
 Types of Hazards
• Physical Hazard

• Moral Hazard

• Morale Hazard
Pure risk is used to designate those situations that
involve only the chance of loss or no loss.
 Life Insurance -Personal Risks
• Personal risks are those risks that directly affect
an individual. They cause financial insecurity
because they usually result in a reduction or
stoppage of income, an increase in expenses
and a depletion of financial resources.
– Risk of premature death
– Risk of poor health
– Risk of temporary or permanent disability
– Risk of insufficient income during retirement
 Insurance
• Insurance is defined as an economic device
whereby the individual can substitute a small
definite cost (the premium) for a large
uncertain financial loss (the risk)
 Insurance features
• Pooling of Losses
• Works when :
– Large numbers
– Definite & Measurable
– Accidental /fortuitous &
– Not catastrophic
 Benefits
• Indemnification of loss
• Reduction of anxiety
• Source of funds
• Loss prevention
• Enhancement of credit
 Costs
• Cost of conducting business
• Inflated claims
• Fraudulent claims
 Basic parts of LI contract
• Parties
• Promises
• Premium & sum insured-death benefit
• Exclusions
• Conditions
• Deductibles
• Riders
• Co insurance
 The Insurance contract
• Offer-acceptance
• Consideration
• Competent parties
• Common intension-meeting of
minds:consensus ad idem
• Legal purpose
 Distinct Contract
• Aleatory contract - are those where the value exchanged is
not equal but depends on an uncertain event
• Unilateral contract- Unilateral contracts are those in which
only one party makes a legally enforceable promise. In the case of
insurance contracts only the insurer makes that promise.
• Adhesion contract- Contracts of adhesion are those that
must be accepted in toto, with all their terms and conditions. In
insurance contracts this means that the insured must accept the
policy issued by the insurer as it is. The insured cannot insist on
any changes or modifications to the contract.
 Insurance Contract
• Conditional Contracts- Conditional contracts are those which
place certain restrictions or limitations on one or both parties.
In insurance contracts the insured must comply with policy
conditions if he wants to collect payment for his claims. In
case of non-compliance of the policy conditions the insurer
can refuse payment.
•  Personal Contracts - This means that the policy is personal to
the insured. With the exception of life insurance, it may not
be assigned to anyone else without the approval of the
insurer.
 Parts of Insurance Contract
• Preamble or Recital Clause
• The operative Clause
• The Attestation Clause
• The Policy Conditions and Schedules
 Parts of Insurance Contract
• Preamble -The preamble of the policy states that the proposal and
declaration, signed by the party, form the basis of contract. The form
contains a schedule which gives all essential particulars of the policy like
name, address, plan of insurance, premium, amount of insurance, etc. On
the back of the policy, the standardized terms and conditions applicable
to all persons insuring under a particular plan are printed. Any special
conditions imposed, are indicated by endorsement.
• Days of grace :Days of grace or grace period is the ‘extra time’ given to
the policyholder for payment of installment premium after the due date,
during which the policy remains in force. It is normally provided for a
period of a fortnight to a month. Grace period is meant to be a
convenience to the policyholders, some of whom may not be able to pay
the premiums on time due to certain preoccupations etc.
 Terms in Insurance Contract
• Revival of Policies :A lapsed policy can be brought back to life through
revival, as if it is a fresh contract, subject to certain restrictions with regard to the
period of lapse etc. The policyholder may however be required to submit a fresh set of
medical and other requirements/declarations at the time of revival. For the purpose
of a claim too, the policy may be treated as new and Sec.45 of the Insurance Act, 1938
be applied.
• Surrender and Paid up Value :Sec.113 of the Insurance Act provides for accrual of
certain benefits to policyholders even if they are unable to keep their policies in full
force by payment of further premiums. If premiums for at least three consecutive
years have been paid, there shall be a guaranteed surrender value. If the policy is not
surrendered, it shall subsist as a paid up policy for reduced sum. The policy conditions
usually provide for a more liberal surrender value and paid up value, than those
secured by the statutory provisions.
• Policy Loans :When a financial contingency arises a Policy Loan is a ready source of
borrowing to a policyholder, It is paid by insurers against the surrender value accrued
to a policy. Policy loans lend liquidity to contracts which are otherwise ‘frozen’ during
the term of the policy.
 Insurance Contract
• Non-Forfeiture Regulations :Non-forfeiture regulations provide
succour to policyholders who are unable to pay premiums due to temporary financial
difficulties. Non-forfeiture regulations allow additional time of, say, six months or a year
for payment of premiums on a policy, even as the risk under the policy continues to be
covered. Insurers offer this privilege after the policy has been in force for a few years and
is not offered on term assurance and some of the ‘high risk cover’ policies.
• Riders: It is possible to tag-along coverage of additional risks to the basic life
product on payment of additional premiums, subject to certain conditions and
restrictions. Such add-ons like accident riders, critical illness riders, premium
waiver riders in case of minor life policies etc are quite popular
• Suicide Clause :As per Indian law suicide is not a crime, but attempt to suicide is a
crime, unlike in English law where suicide is a crime. Hence, contracts of insurance that
agree to pay the sum assured even in the event of the death of life assured due to suicide
are not against public policy. But, to avoid a possible moral hazard and adverse selection,
insurance companies do place a restrictive clause by not covering death as a result of
suicide up to one year from the date of commencement of policy or date of issuing of
policy, whichever is later.
 Insurance Contract
• Pregnancy Clauses :On life insurance policies issued during the
pregnancy of a female proponent, life insurers apply this clause to exclude
coverage of pregnancy / child birth related deaths.
• Specific clauses on female lives :Certain classes on female lives such as
females in the age group of 20-35 who have no earned income are susceptible
to moral hazard. To avoid this risk, insurance companies do impose these
clauses excluding coverage of accidental death in other than public places
• Occupation related clauses :To exclude the risks that are closely related
to the occupation (like that of a pilot whose occupation is prone to aviation
risks) of the life assured, insurance companies do levy these clauses excluding
the risk coverage owing to the death of the life assured during the course of
employment. Ex: Aviation clause,Divers’ clause.
 Insurance Contract
• Lien Clause :In respect of certain types of high risk life insurance policies
where insurers have a lower level of comfort due to the adverse disclosures made
in application for life insurance and where insurance coverage cannot be denied
based on such disclosures, life insurance companies do impose the lien clause
which could either limit the liability of the insurer during a specified period [like
50% of sum assured during first year,75% in the second year and 100% from the
third year onwards]; or defer the coverage for a specified period [like no life cover
during first year of the policy].
• Life insurers also reserve the right to impose a clause during the term of the policy
through a clause based on the future occupation that a minor life may engage in.
Under the current clause, insurers require the minor life to notify them in the event
of minor life engaging in hazardous occupations. On receipt of information from the
life assured on his reaching the majority or on his joining the services of hazardous
occupations, life insurers may apply such occupational clauses as deemed
necessary. Hence, policies issued to minor lives, will be subject to these clauses.
 Insurance Contract
• Endorsement : is an attachment appended to the policy
document itself effected to amend the terms of conditions in the
original policy.For example: Assignment or transfer of a life
insurance policy may be made by simply making an endorsement
to that effect in the policy document.
• Nomination
• Assignment
• Inconstable Clause
 Other Provisions
• Spes successionis :This phrase means “hope of succession”. The principle of
insurance law is that only a person having an insurable interest in the subject
matter of insurance can seek and sustain any right in an insurance policy. Any
hope of succession or any expectation of stepping into the shoes of the assured
cannot give a locus standi to a third person to sustain a proceeding in matters
related to insurance proceedings.
• Pari Delicto :The phrase signifies that both parties are equally blamed. This
doctrine is applicable on issues involving return of premium. The general rule is
that where a policy by existence is an illegal policy, the premium cannot be
recovered or returned. It has to be proved that both the parties are in pari delicto
for an insurance company to avoid a return of premium.

•  Salus populi est Supreme Lex :This principle means that the regard for
public welfare is the highest law.
 Other Provision
• Res ipsa loquitor :This phrase signifies
that “things speak for themselves or the thing
speak for itself”. The principle provides that
under certain circumstances the mere fact of
occurrence of an accident raises an inference
of negligence so as to establish a prima-facie
case.
 Principles of Insurance
• Utmost good faith-doctrine of “uberrima fides”:
material facts disclosure,misrepresentation,Non
disclosure-Proposer of Insurance
• Insurable interest-by law, contract ,statute
• Indemnity-mechanism by which insurance co.
attempts to place insured in the same position
immediately prior to loss.
• Subrogation
• Contribution
• Proximate Cause
 Principle of Insurable Interest
• LI
• Every person has an unlimited insurable interest in his own life. His ability to get himself
insured is restricted only by his ability to pay the applicable premium.
• A person also has an automatic insurable interest in the life of his / her spouse.
• A person has insurable interest in the life of debtor, but only to the extent of the loan
outstanding.
• In Property Insurance:
• The absolute owner has insurable interest in the property owned by him / her.
• Any person, who has partial or joint interest in some property, is entitled to insure to the extent of
the full value of the property, rather than just the extent of actual interest. In such cases he will be
deemed an agent for the balance.
• Mortgagees and Mortgagors both have insurable interest. Here, the purchaser’s (mortgagor) interest
arises because of ownership whereas the mortgagor’s interest arises as a creditor which is limited to
the extent of the amount of loan.
• Trustees/ executors/ administrators are legally responsible for the property in their charge.
• A bailee is a person who legally holds the goods of another e.g. workshops, drycleaners etc.They
• have insurable interest as they have the responsibility to take reasonable care of the goods.
• Where a principal has insurable interest, his agent can effect insurance on his behalf.
• Spouses have insurable interest in each other’s property.
 Insurable Interest -In Liability
Insurance
• A person has insurable interest to the extent of any potential liability
which may be incurred by way of damages or costs. For example a drug
manufacturing company may incur a liability due to ill effects of a new
drug.
• In liability insurance it is not possible to predetermine the extent of
interest because there is no way of knowing how and when one may incur
liability and what would be the monetary value of the liability.
• In practice, a realistic judgment is made by the insured about the
maximum liability that may be incurred and insurance procured for that
amount, unless any relevant statute has fixed some limits.
 Methods Indemnity
• Cash:In this method the insurance company simply pays the cheque for
the amount payable under the policy and gets discharged of their
liabilities.
• Repairs:The insurers may get the damages repaired on their own, e.g. in
motor insurance, the insured need not pay the cost of repairs as it is
directly paid by the insurance company to the mechanic / workshop.
• Reinstatement:This method is mostly used in fire insurance for building or
machinery where the insurance company undertakes to repair the
damage or reconstruct the building.
• Replacement:Insurers may undertake the replacement of the damaged
item e.g. a broken plate glass window in a showroom.
 Measuring -Indemnity
•  Property Insurance:Not by the cost of the property, but by the value at the
date of loss and at the place of the loss.If the value has increased during the
currency of the policy, the insured is entitled to an indemnity on the basis of the
increased value. This rule is, however, subject to policy conditions such as the
total sum insured etc.
• In assessing the amount of indemnity, the following are not considered:
• _ Loss of Prospective Profits
• _ Consequential Losses
• _ Sentimental Value
• Building Insurance: The cost of repair or reconstruction at the time of loss. An
allowance for betterment is deducted from the indemnity payable.
• Insurance of Household Goods:Indemnity is based on the cost of replacing
items at the time of the loss, subject to deductions for wear and tear.
• Two different types of covers are generally available for household goods.
• _ Indemnity only
• _ New for old ;there is no deduction for wear and tear. Indemnity is calculated
at replacement at current market price.
 Measuring -Indemnity
• Liability Insurance:
• Amount of indemnity is the amount of any court award or negotiated “out
of-court” settlement plus costs and expenses arising in connection with
• the claim.
 Factors limiting payment
• Sum insured:The total sum insured is the limit of maximum amount
recoverable under the policy even if the calculated amount of indemnity is
higher. Indemnity can exceed the sum insured if the policy is not updated for a
long time and in that duration the value of the property increases.
• Exceptions:At times, in marine insurance policies, some loss minimization
expenses are paid even in excess of sum insured.
• Depreciation:The value of an asset decreases over time due to constant use.
So the amount towards depreciation due to wear and tear is generally
deducted.
• Salvage:In case of partial loss, the property may remain in a deteriorated or
damaged condition. If the insurance company has agreed to pay the loss in
full, it is entitled to any materials left. If the left over parts are not
• deposited with the insurance company, the amount payable is reduced by the
value of salvage. This is common practice in motor insurance policies.
 Factors limiting payment
• Average:If at the time of loss the value of the property insured is more than the sum
insured, then the insured would be considered his own insurer for the difference. Thus in
the event of loss, the amount is shared between the insurer and the insured in the
proportion of sum insured and the amount of under insurance.
• Excess: An excess is the initial amount of each and every claim that is supposed to be
borne by the insured himself. The objective is to eliminate the small losses which may
involve comparatively high administrative cost for the insurer. Excess is of two types –
Voluntary and Compulsory. Voluntary excess is voluntarily opted by the insured and
results in reduction of premium whereas compulsory excess does not result in any
reduction.
• Limits: Many policies limit the amounts to be paid for certain events by the wording of
the policy itself. For example universal health insurance policies often specify a limit of
Rs. 15,000 per claim.
• A franchise is similar to a deductible in that the insurer makes no settlement if the total
claim is below the franchise figure. However, if the claim is above the franchise figure,
the claim is paid in full. Franchises are very unusual in modern insurance practice though
machinery breakdown covers sometimes use time franchises.
 Subrogation
• This principle is corollary to the principle of indemnity in the sense that it
prevents the insured to be benefited by loss after receiving the loss from the
insurer as well as the responsible third party. The insured may recover the loss
from another source after receiving the claim from the insurers, but, that
additional money must be given to the insurers.
• Subrogation applies only when there is a contract of indemnity. It is not
applicable in life insurance, personal accident insurance as these are not
subject to the principle of strict indemnity.
• Definition:Subrogation is the right of one person (insurer), having indemnified
another (insured) under a legal obligation to do so, to stand in the place of
that other (insured) and avail himself (insurer) of all the rights
• and remedies of that other, whether already enforced or not.
• Extent of Subrogation rights
• This principle does not apply only to the insured but also to the insurer as
insurers are not entitled to recover more than what they have paid as claim.
Just like the insured, the insurer must also not make any profit out of an
insurance claim.
 Contribution
• In some cases more than one policy may be in force on the same subject
matter at the time of loss. In that circumstance each insurer would need to
bear a proportion of loss. This is referred to as Contribution.
• Contribution is the right of the insurer to call upon others similarly (but not
necessarily equally) liable to the same insured to share the cost of an
indemnity payment. If an insurer has paid the indemnity in full, he can recover
an equitable proportion of the risk from other insurers.
• The following features are to be met before the condition of contribution
arises:
• _ Two or more policies of indemnity must exist;
• _ The policies must cover the same interest;
• _ The policies must cover a common peril which gives rise to the loss;
• _ The policies must cover a common subject matter; and
• _ Each policy must be liable for loss
• It is not necessary for the policies to be identical to each other. There should,
however, be an overlap in such a manner that both policies are liable for
payment of indemnity.
 Basis of Contribution
• Contribution is usually calculated on the basis of
‘Rateable Proportion’. This means that each insurer
contributes towards paying the loss in proportion to the
sums insured on the policies.

• Even if the property is underinsured, the insured is

considered to be his own insurer for the uninsured
amount. Thus, as per the concept of rateable proportion
the insured is supposed to contribute towards bearing
the loss with respect to the uninsured amount.
 Principles of proximate cause
• Single or last in the series cause
• In the event of loss, the burden of proof is on the insured. He has to prove
that the proximate cause of loss was an insured peril.
• If the insurance company argues that the loss was caused by an excepted
peril, the onus of proof shifts to them.
• The doctrine is also modified by express policy conditions especially in fire
and accident policies. The condition is usually worded in a manner so that
the loss caused proximately or remotely, directly or indirectly, by an
excluded peril, is outside the scope of the policy.