Risk Management and the Insurance link!

So, as promised, here’s an introduction to risk management!

As they say, life is full of risks - some are preventable or can at least be minimized, some are avoidable and some are completely unforeseeable. What's important to know about risk when thinking about insurance is the type of risk, the effect of that risk, the cost of the risk and what you can do to mitigate the risk?

Now, in simple terms, mitigating the risk means taking care of the risks. Or reducing it. So, when you play cricket and wear helmets and pads and all the accessories, you are mitigating your risk of getting injured! And taking that analogy, when you buy a motor insurance, you are insuring yourself against accidents and insuring your loss of vehicle. You are mitigating these risks.

Let's take the example of driving a bike.

                       

Type of risk: Injury, Complete Bike gone, having to fix your bike

The effect: Spending time in the hospital, having to rent a car and having to make EMI payments for the bike which no longer exists! 

The costs: Can range from small to very large. Think of just fixing the brakes to changing the whole Fuel tank, shockers, and wheels. All combined!

Mitigating risk: Not driving at all (risk avoidance), becoming a safe driver (you still have to contend with other drivers and especially those Truck Drivers on the NH 24), or transferring the risk to someone else (insurance).

So, as we have seen, Risk is a condition whereby there is a possibility of loss occurring. In insurance the subject matter insured is called the Risk( You having a bike crash or your house getting, in the previous  article!).

There are two main components in definition of risk:

i) Uncertainty: Uncertainty refers to a situation where an event may or may not happen.

For eg. a building may or may not have a fire accident.

ii) Undesired consequences: Undesired consequences refers to the negative results that may arise out of an event, such as a fire accident which may result in damage to a property as well as result in consequential loss of business due to stoppage of work.

Other two things that is important to note is that Risk is distinguished from peril and hazard. Peril is a cause of loss, eg. fire. Hazard is a condition that may create or increase the chance of a loss arising from a given peril.

So, risk is that you will get cancer; Peril is that your lungs will go haywire and smoking is the hazard! Simple enough!

Let's explore this concept of risk management (or mitigation) principles a little deeper and look at how you may apply them. The basic risk management tools indicate that risks that could bring financial losses and whose severity cannot be reduced should be transferred.

            

                                                         Risk Management!

So, the basic idea for Risk Management is that first of all, you have to identify the risks. Or what we call Asses the risks. So, when you realized that you might get into an accident or some other truck wala will run you over, you realized and identified the risk you are having.

That’s about Identification of the risk!

So, after identifying the risks, you will analyze what needs to be done to mitigate the risk! Will you be able to pay the amount involved if you get involved into accident, broke your bike or your bones or both! Say, everyone in your city is such a good driver that they have never been into an accident and the chances that you will get into an accident are so less or almost negligible that paying the premiums is actually a waste of money! Or if you live in a city like Delhi, where accidents are so common that you will not even think before signing that cheque for premiums!

So, what we did in the previous steps is what we call Analysis of Risk or Risk Assessment!

Next comes what we Risk Treatment, wherein we do risk planning.There are two ways that risks can be controlled. You can avoid the risk altogether, or you can choose to reduce your risk. So, based on the city you live, you will decide whether yo take the risk yourself or pass on the risk to some insurance companies. That is what we call Risk Financing! If you decide to transfer the risk, you can then transfer the risk to some insurance company. This is also where the concept of Risk Sharing comes in, where you pay the premiums and share the risk of a bike accident with fellow riders or share the risk if your house getting burnt!

For risks that involve a high severity of loss and a low frequency of loss, then risk transference (ie. insurance) is probably the most appropriate protection technique. Insurance is appropriate if the loss will cause you or your loved ones a significant financial loss or inconvenience. For risks that are of low loss severity but high loss frequency, the most suitable method is to keep the risk with yourself (say, you getting a cold!). In other words, some damages are so inexpensive that it's worth taking the risk of having to pay for them yourself, rather than forking extra money over to the insurance company each month. 

The last step is monitoring those risks, keeping a check on the finances so that cost of transferring the risk doesn't become greater than the risk itself!  And even if you have transferred the risk, it is better to avoid the realization of those risks than face them!

So, after an introduction to Risk Management, I will be taking up Risk Management from the point of view of Insurance Companies and how they actually make money!