Classifications of Risk and Loss Exposure.
Risk: A situation in which several different outcomes are possible.
Pure Risk Events: Two possible future states of the world:
2. No Loss
Random events cause the possible future states of the world to occur. Personal, Property and Liability Pure Risk generally are insurable.
Speculative Risk Events: Three possible future states of the world:
* No Loss or Gain
Random events cause the possible future states of the world to occur. Generally are NOT insurable.
Diversifiable Risk: A risk that affects only some individual, business and small group. Risk of fire which is likely to effect only one or small number of business. Investor normally invest in different sectors to diversify their investment risk. Generally are insurable.
Non-diversifiable Risk: A risk that affects a large segment of society at same time.
For Example under certain monetary conditions interest rates will increase for all firms at the same time. If an insurer want to insure firms against interest rate increases. It would not be able to diversify it portfolio of interest rate risk. Generally are not insurable.
Particular Risks: A risk that affects only individual and not the entire community. Only individuals experience losses rest of the community left unaffected. Examples of Particular risk are Burglary, theft and auto accident. Generally are insurable.
Fundamental Risks: A risk that affects the entire economy or large numbers of people or groups within the economy. Examples of fundamental risks are unemployment, war and natural disasters such as hurricanes, tornadoes and floods. Generally are not insurable. Government assistance may be necessary in order to insure fundamental risks.
No consensus exists about how an organization should categorize its risk, one approach involves dividing them into risk quadrants:
* Hazard Risks
* Operational Risks
* Financial Risks
* Strategic Risks
Hazard risks arise from property, liability, or personnel loss exposure and are generally the subject of insurance.
Operational risks fall outside the hazard risk category and arise from people or a failure in process, systems, or controls, including those involving information technology.
Financial risks arise from the effect of market forces on financial assets or liabilities and include market risk, credit risk, liquidity risk and price risk.
Strategic risks arise from trends in the economy and society, including changes in the economic, political and competitive environments.
Hazard and operational risks are classified as pure risks
Financial and Strategic risks are classified as Speculative risks
Individual and organizations incur losses when assets they own decrees in value. Situations or conditions that expose assets to loss are called loss exposure. Any condition or situation that presents a possibility of loss whether or not an actual loss occurs.
In order to effectively manage risk, individual and organizations must identify all the loss exposures they face.
Every Loss exposure has three elements:
* An assets Exposed to Loss
* Cause of Loss (also called peril)
* Financial Consequences of that Loss
1. Assets Exposed to Loss:
* Assets owned by organization. Like Property, Building, Furniture and Fixture, Automobiles, Investments, Money, Hum Resources,
* Intangible Assets include Patents, Copyrights, Trademark,
* Assets owned by individuals. Like Property, Building, Furniture and Fixture, Automobiles, Investments, Money
* Intangible Assets include Professional Qualifications, Unique skill set, Valuable Experience
2. Cause of Loss:
Cause of Loss includes Fire, Riot Strike Damage, Explosion, Burglary, Earth Quake , Atmospheric Disturbance are some examples of cause of loss that present a possibility of loss to property? Hazard Anything that increase chance of loss or increase the frequency or severity of loss. Like slippery Road, Oil storage near to Machinery, Defective wiring.
* Physical Hazard
* Moral hazard
* Morale Hazard
* Legal hazard
Physical Hazard: Tangible Characteristics of property, persons or operations that tend to increase the frequency and severity of loss Like Slippery Road, Explosion in chemical area that has inadequate ventilation, Fire due to defective wiring.
Moral Hazard: Conditions that increases the likelihood that a person will intentionally cause of exaggerate a loss. Moral hazard results from deliberate act. Like Filing False Claim, Inflating a claim, Intentionally causing a loss.
Morale Hazard: A Condition of carelessness that increases the frequency or severity of loss. Like Driving Carelessly, Failing to unlock unattended building'
Legal Hazard: A Condition of the legal environment that increases the frequency or severity of loss. Like court Attitude to grant large damages award in liability cases. Increasing No. of decision against Tobacco companies.
3. Financial Consequences of Loss:
Financial consequences of loss depend on type of loss, loss frequency and severity.
For example value of building , value of business, profits.
Types of Loss Exposures: Loss Exposures are normally divided in four types i.e. Property Loss Exposure, Liability loss Exposure, Personnel Loss Exposure, Net income Loss Exposure.
Property Loss Exposure:
A property Loss exposure is a condition that presents that a person or an organization will sustain a loss resulting from damages to property in which that person or organization has a financial interest. Property can be categorized as either Tangible property and Intangible property.
Tangible property has a physical form, such a building, Car, Motorcycle, Jewelry and Equipment's etc. Tangible property can be further sub divided into:
* Real property consisting of land and all structures permanently attached to the land and whatever is growing on land.
* Personal property - All tangible property that is not real property. Like Vehicles, jewelry etc.
Intangible property has no physical form such as a Trade Mark, good will, Trade Secrets copyright and Trade Slogan. Damage to property can cause are education in property value, sometimes to Zero. For Example when property is Total loss, like stolen of property. Property damage can also result in loss of income when property cannot be used to generate income.
Liability Loss Exposure:
Any condition or situation that presents that possibility of a claim declaring legal responsibility of a person or business for injury or damage suffered by another party. Like Third party Liability, Product Liability, Public Liability, Professional Liability, Auto Liability, Employer Liability.
Personnel Loss Exposure:
Presents death disability, retirement or resignation that deprives an organization of the person special skill or knowledge that the organization cannot readily replace. A key employee can be an individual employee, an owner, an officer or manager of the organization who possess special skills or knowledge that is valuable to the organization.
Personal Loss Exposure:
If the Key employee is viewed in terms of his or her family, the loss exposure associated with the loss of that key person is often called a personal loss exposure. The possibility of a financial loss to an individual or a family by such causes as death, sickness, injury or unemployment. e.g Death of bread winner.
Net Income Loss Exposure:
A condition that presents the possibility of loss caused by a reduction in net income. Both individual and organization have net income loss exposure for example a fire in a factory production facility not only destroy factory (a property loss exposure) but also force organization to stop operations for few weeks result in loss of sale revenue (a net income loss exposure) similarly a fire in retail store of self-employed business owner, the inability to earn income while store is being repaired represents a net income loss exposure. Net income losses are often the result of a property, liability or personnel loss (all of which are direct losses). Therefore net income losses are considered to be indirect losses.
A Direct Loss is a loss that occurs immediately as the result of a particular cause of loss, such as building damage by fire.
An Indirect Loss is a loss that results from not particular cause of loss.