Risk & Insurance in International Trade

Recommended Books:
 Risk Management in International Trade by MP
Singh & V.S. Chopra
 Risk & Insurance by Rejda ( Pearson
Publication)
 International Financial Management by P.G.
Apte
 Foreign Exchange Management by C.
Jeevanandan
Risk: Introduction & Basic Concepts

Prof Mahesh Kumar

Amity Business School
profmaheshkumar@rediffmail.com
A Comment

“I am more interested in the return of

my money than return on my money”

Mark Twain

3
Introduction
 If a cost or a loss is certain to occur, it may be
planned for in advance and treated as a
definite known expense.
 Person is usually more concerned about the
risk of abnormal losses than about normal and
expected losses.
The Burden of Risk
How does risk create an economic burden?
 Risk may necessitate the setting aside of a
reserve fund (which has an opportunity cost) to
meet losses if and when they do occur.
 The existence of risk not only raises the cost to
society of certain services but may also deprive
society altogether of services ‘too risky’ to
warrant the investment of savings. There is
shortage of ‘risk capital’ in all nations because
most investors prefer a significant degree of
safety.
The Burden of Risk
 In other words, the riskier the venture, the
greater the return must be promised to
investors; hence the more costly that particular
service is to the society. And if the risk is too
high the service may be withdrawn.
The Burden of Risk
Illustration of how risk discourages risk capital
formation is seen in a simple experiment:
 Ask a person if he or she would prefer
a) To accept a gift of Rs.1000 in cash or
b) To flip a coin for Rs.2000 if head comes up, but
nothing if tails comes up.
 Most of the people would hesitate to pass up a
certain Rs.1000 for all-or-nothing chance at
Rs.2000.
The Burden of Risk
 Most people try to avoid risk as much as
possible or to reduce its negative
consequences.
 Unfortunately not all risks can be minimized or
avoided.
 To maximize our insulation from the adverse
impact of risk, we must study the subject
scientifically, learn more about the specific
nature of the different types of risk and find
ways to deal with risk more effectively.
Risk- Defined
 There is no single definition of risk. Risk
traditionally has been defined as uncertainty
concerning the occurrence of a loss.
 Example the risk being killed in auto accident is
present because uncertainty is present. The
risk of lung cancer for smokers is present
because uncertainty is present. And the risk of
flunking a college course is present because
there is uncertainty concerning the grade you
will earn.
Risk
 A particular risk is consciously analyzed and
managed; other times the risk is simply
ignored, perhaps out of lack of knowledge of
its consequences.
 An entity’s cost of risk is the sum of :
1. Expenses of strategies to finance potential
losses.
2. Cost of un reimbursed losses.
3. Outlays to reduce risk.
4. The opportunity cost of activities foregone due
to risk considerations.
Types of Risk: Pure V/s Speculative Risk
 Pure risk is defined as a situation in which there are
only possibilities of loss or no loss. Loss can be
personal, property or liability.
Examples of pure risk include premature death, job
related accidents, catastrophic medical expenses and
damage to property from fire, lightning, flood or
earthquake.
 Speculative risk is defined as a situation in which either
profit or loss is possible.
Examples: If you purchase 100 shares of common
stock, you would profit if the price of the stock
increases but would lose if the price declines. Other
examples are betting on a horse race, investing in real
estate and going into business for yourself.
Types of Risk: Pure V/s Speculative Risk
Pure risk and speculative risk should be distinguished for
three main reasons:
1. Private insurers generally insure only pure risk while
speculative risk are not considered insurable.
( Exception is the insurance of institutional portfolio
investments and municipal bonds against loss).
2. The law of large numbers can be applied more easily to
pure risk than to speculative risk. An exception is the
speculative risk of gambling, where casino operators
can apply the law of large numbers in a most efficient
manner.
Types of Risk: Pure V/s Speculative Risk
3. Society may benefit from speculative risk even
though a loss occurs, but it is harmed if pure
risk is present and a loss occurs.
Example: A firm may develop new technology
for producing computers more cheaply. As a
result, some competitors may be forced into
bankruptcy. Despite the bankruptcy, society
benefits since the computers are produced at a
lower cost. However a society normally does
not benefit when a loss from a pure risk
occurs, such as flood or earthquake that
devastates an area.
Types of Risk: Static V/s Dynamic Risk
 Static risk can either be pure or speculative risk
and is a risk that stems from an unchanging
society that is in stable equilibrium.
Examples include losses due to random events
such as lighting, windstorms or death.
 Dynamic Risk can also be either pure or
speculative and are produced because of changes
in society.
Examples include urban unrest, increasingly
complex technology and changing attitudes of
legislatures and courts about a variety of issues.
Types of Risk: Static V/s Dynamic Risk
Dynamic Risk Static Risk
1. Losses resulting from 1. Losses occur even if
changes in environment. there is no change in
2. Losses cannot be easily environment.
predicted. 2. Losses easily predictable
3. Are not suited for 3. More suited for
treatment by insurance. treatment by insurance.
4. Normally benefits the 4. Not a source of gain to
society. society.
5. Dynamic risk causes 5. Static losses involve
relate to the changes in destruction of asset or
price level, consumer change in its possession
wants and needs, as a result of dishonesty
income etc. or human failure.
Types of Risk: Fundamental & Particular Risk
 A fundamental risk is a risk that affects the entire
economy or large number of persons or groups within
the economy.
Examples include high inflation, cyclical unemployment,
war because large number of individuals are affected
and natural disasters.
 A particular risk is a risk that affects only individuals
and not the entire community.
Examples are car thefts, bank robberies and dwelling
fires.
 The distinction between a fundamental risk and a
particular risk is important because government
assistance may be necessary to insure a fundamental
risk.
Types of Risk: Objective V/s Speculative Risk
 Objective Risk is defined as the relative variation of
actual loss from expected loss. It is also known as
statistical risk.
Obj Risk= Probable Variation of Actual from Probable loss
Probable losses
 Subjective risk is defined as uncertainty based on a
person’s mental condition or state of mind.
 The impact of subjective risk varies depending on the
individual. Two persons in the same situation may have
different perception of risk, and their behavior may be
altered accordingly.
 High subjective risk often results in conservative and
prudent behavior while low subjective risk may result in
less conservative behavior.
Types of Risk: Objective V/s Speculative Risk
Examples
 Banker A refuses a loan proposition that Banker B
accepts & under equivalent conditions.
 Student B graduates and accepts a position paying a
low initial salary but offering an opportunity for a large
income for few who succeed in the company; Student A
graduates and accepts a position paying a higher salary
than B’s position pays, but under conditions limiting the
opportunities for advancement.
 Consumer A is offered certain types of goods over
telephone but refuses to buy; Consumer B, offered the
same goods, but even without full information.
 Business A insures the plant against fire even though
the premium may be very high while business B a
neighbor operating under similar conditions, refuses the
insurance.
Types of Risk: Objective V/s Speculative Risk
 In all the above examples, A can be described
as apparently perceiving a higher degree of
risk in the given situation and behaving more
conservatively than B. A tends to be risk
averter and B a risk taker.
Degree of Risk
 A high degree of subjective risk exists when a
person experiences great mental uncertainty
as to the frequency of occurrence of some
event that may cause loss and as to the
amount or severity of this possible loss.
Generally high subjective risk produces very
conservative conduct and low subjective risk
tends to produce less conservative conduct.
Degree of Risk
 Objective risk on the other hand, varies
according to the ratio of probable variation of
actual from probable loss. If the loss has
happened the probable variation is zero and
thus objective risk is also zero. Similarly if it is
impossible for the loss to happen, the probable
variation is zero and the objective risk is still
zero.
 Risk must be dealt in advance of the event
when the loss is still unknown and uncertain.
Risk V/s Probability
 Probability refers to the long run chance of
occurrence or relative frequency of some
event.
 Insurers are interested in the probability or
chance of loss, or more accurately, the
probability that a loss will occur to one of a
group of insured objects.
 Probability has little meaning if applied to the
chance of occurrence of a single event. It has
meaning only when applied to the chance of
occurrence among a large number of events.
The Law of Large Numbers
 The law of large numbers is operating in the
case of the insurer but not in the case of
individual insurer.
 The law of large numbers, a basic law of
mathematics states that as the number of
exposure units increase, the more certain it is
that actual loss experience will equal probable
loss experience. The risk diminishes as the
number of exposure units increases.
 Objective risk varies inversely with the
square root of the number of exposures.
Objective Risk & The Law of Large Numbers
 Example: Assume that a property insurer has 10000
houses insured over a long period, and, on average,
1 percent, or 100 houses, burn each year.
 However, it would be rare for exactly 100 houses to
burn each year. In some years, as few as 90 houses
may burn; in other years as many as 110 houses
may burn. Thus there is a variation of 10 houses
from expected number of 100, or a variation of 10
percent. This relative variation of actual variation
from expected loss is known as objective risk.
Objective Risk & The Law of Large Numbers
 Now we assume that 1 million houses are
insured. The expected number of houses
that will burn is now 10000, but the variation
of actual loss from expected loss is only 100.
Objective risk is now 100/10000 or 1
percent.
 Thus, as the square root of the number of
houses increased from 100 in first case to
1000 in the second, objective risk declined
to one tenth of its former level.
Effect of Probability on Objective Risk
 At the first glance it appears that higher the
probability, the higher the risk.
 Rather, the opposite is true because as probability
increases, the variation of average losses from
probable losses tends to decrease, assuming a
constant number of insured exposure units.
 We know that as a loss becomes more and more
certain to happen, there is less and less
uncertainty (i.e. less risk) that it will not happen. If
a point is finally reached where an event is bound
to happen, there is no risk at all.
Effect of Probability on Objective Risk
 Example: Assume that employers A and B each
with 10000 employees, desire to insure themselves
against occupational injuries to workers.
 Employer A is in a ‘safe’ occupation, and the
probability of disabling injury in A’s plant is 0.01
 Employer B is in a ‘dangerous’ occupation and the
probability of disabling injury in B’s plant is 0.25.
 In long run, Employer A may expect 100 disabling
injuries per year compared with 2500 for Employer
B.
Effect of Probability on Objective Risk
 There is about a 95% chance that the probable
variation in injuries in A’s plant will not exceed 20
while in B’s plant the probable variation will not
exceed 87.
 Thus objective risk in A’s situation is 20/100 or
20% compared with 87/2500 or 3.5% for B.
 Although B’s objective risk is only about 17%
(3.5/20=0.175) of A’s objective risk, B’s
probability of loss is much large.
 Thus objective risk varies inversely with the
probability for any constant number of exposure
units.
Summary
To summarize the two most important applications of
the law of large numbers as it affects objective risk:
1. As the number of exposure units increase in an insured
group, objective risk decreases. Specifically, objective
risk varies inversely with the square root of the number
of exposure units, other things remaining the same.
2. Given a constant number of exposure units as the
probability of loss increases, objective risk decreases. In
general, the rate of decrease in objective risk is less
proportionate to the rate of increase in probability of
loss.
The Insurers Risk
 From the above one might erroneously
conclude that an issuer would always charge a
lower premium as the probability of loss rose
because of the reduced risk.
 It is probability of loss that governs the
amount of premium charged in a given
situation.
The Insurers Risk
 If an insurer had so few in an insured group
that it would not be possible to determine just
what the losses might be- i.e. objective risk
was high- the insurer would tend to assume
the worst and charge for coverage based on
the worst possible result. In effect, the insurer
charges both for risk and for expected losses.
 In the event that the insurer is able to attract
a sufficiently large group of insured, thus
reducing or eliminating objective risk, the
charge for risk greatly diminishes.
The Insurers Risk
 Frequently an insurer is asked to offer
coverage on a single exposure unit. In such an
event the law of large numbers is of no help to
the insurer, who must rely on personal
judgment and quote a rate based on
subjective attitudes towards the risk. In such a
situation, the risk may properly be termed as
subjective risk.
The Insurers Risk
 In practice, the insurer’s risk is reduced considerably
because of the operation of the central limit
theorem, of which law of large numbers is a special
case.
 Under the central limit theorem, the insurer’s loss of
a given kind may be viewed as samples taken from a
large universe of losses. The means of these samples
are distributed ‘normally’. Here the variations from
the average may be stated with known degree of
confidence. Thus the insurer may be able to predict
losses within a known range. The relative size of the
range is the insurer’s measure of objective risk.
Hazards and Perils
 A peril may be defined as a contingency that may cause a
loss and a hazard as the condition that introduces or
increases the probability of loss from a peril.
 Example: One of the perils that can cause loss to an auto
is collision. A condition that makes the occurrence of
collisions more likely is an icy street. The icy street is the
hazard and the collision is the peril.
 The definition of hazard might also be expanded to
include conditions that makes the loss more severe, once
the peril has been realized and has caused a loss.
 There are three types of hazards that not only increase
the probability of loss but also increase the severity of
loss once it occurs. They are physical, moral and morale.
Physical Hazards
 A physical hazard is a condition stemming from the
physical characteristics of an object that increases the
probability and severity of loss from given perils.
 Example: Existence of dry forests (hazard for fire), earth
faults (hazard for earthquakes) and iceberg (hazard for
ocean shipping).
 Such hazards may or may not be within human control.
 Example: Hazards for fire can be controlled by placing
restrictions on building camp fires in forests during dry
season. Some hazards, however cannot be controlled-
little can be done to prevent or control air masses that
produce ocean storms.
Moral Hazards
 A moral hazard stems from the mental attitude
of the insured.
 Because of indifference to loss or owing to an
outright desire for loss to occur, the individual
either brings about personal loss or
intentionally does nothing to prevent its
occurrence or to alleviate its severity.
 Moral hazards are typified by individuals with
known records of dishonesty or indifference.
Moral Hazards- Examples
 Moral hazards may exist in situation where
excessive amounts of fire insurance are
requested on ‘white elephant’ properties
(properties that are no longer profitable) where
an incentive may exist to ‘sell the building to
the fire insurance company.’
 Every underwriter knows that fire losses are
more frequent in depression periods.
Morale Hazard
 Even though an individual does not want a
loss, there may be sub conscious desire for a
loss.
 The morale hazard includes the mental attitude
that characterizes an accident prone person.
 This type of individual does not appear to
deliberately cause the accidents that happen,
but the psychologist would probably diagnose
the cause of excessive and repeated accidents
as a sub conscious problem of morale.
Adverse Selection
 There is a tendency for those who are in a position to
have a loss and who need protection against it to be the
only ones in a larger group who apply for protection.
 Insurance underwrites are trained to recognize such
situations; they refer to them as adverse selection or
anti selection.
 Examples: Those in the low areas of flood zones may be
the only applicants for flood insurance. Those applying
for life annuities are more likely to have histories of long
life in their families; those whose parents died early may
be more likely to seek life insurance.
 Adverse selection tends to make some lines of insurance
unavailable or very restrictive.
Adverse Selection
 If not controlled, adverse selection result in
higher-than-expected loss levels
 Adverse selection can be controlled by:
1. careful underwriting (selection and
classification of applicants for insurance)
2. policy provisions (e.g., suicide clause in life
insurance)
Managing Objective Risk
 Individuals cannot reduce their objective risk unless
they control a large enough number of exposure units
and obviously most people cannot meet this condition.
 For convenience, the ways of handling risk may be
grouped under the following heads.
1. Assume the risk (risk retention)
2. Combining the objects subject to risk into large enough
group to enable accurate predictions of loss (includes
the insurance mechanism) diversification, a method
similar to combining risks.
3. Transferring or shifting the risk to some other individual.
4. Utilizing loss control activities.
5. Avoidance of risk.
Risk Assumption or Retention
 Risk assumption (also called risk retention) is
the most widely used of all ways to handle risk
and may be planned or unplanned.
 Planned risk retention, often called self
insurance is conscious and deliberate
assumption of recognized risk. The individual
or firm decides to pay losses out of currently
available funds. In some cases a reserve or
‘rainy day’ fund may be established to cover
expected losses.
Risk Assumption or Retention
 Some persons erroneously assume that establishing a
reserve fund is equal to insurance against losses. There
is an important difference.
 If a person saves Rs.10000/- in the bank for a hospital
bill, this person has no way of knowing whether or not
this fund is adequate. A single period of hospitalization
could easily exhaust the savings and a second period of
hospitalization might occur before the savings could be
restored. Thus the risk of loss of savings due to illness
requiring hospitalization has not actually been reduced.
However a properly drawn insurance plan in which risk
of loss is effectively transferred to another will take care
of an indefinite number of hospitalization.
Risk Assumption or Retention
 Unplanned risk retention exists when a person
does not recognize that a risk exists and
unwittingly believes that no loss could occur.
Such a ‘method’ does not deserve to be called
a risk management device. It stems from
ignorance of risk.
 ID NON-SANABILE SINGULATIM
CURANDUM EST GREGATIM

IF RISK CANNOT BE AVOIDED

INDIVIDUALLY, MITIGATE IT COLLECTIVELY.
Combination of Objects Subject to Risk
 This involves the use of large numbers. When
sufficiently large numbers are grouped, the
actual loss experience over a period of time will
closely approximate the probable loss
experience.
Combination of Objects Subject to Risk
 Historical Fact: Early Chinese merchants were
masters at using the combination method of
reducing risk. They took periodic trips inland to
gather merchantable products for sale on the
coast. In traveling down Yangtze River, the
merchants would gather above the rapids and
redistribute their cargoes so that each boat had
a small portion of the other merchant’s cargo
aboard. Thus, if one boat were lost in the
rapids, no one merchant would have suffered a
total loss.
Combination of Objects Subject to Risk
 Commercial insurance companies simply
persuade large number of individuals, known
as insureds or assureds, to pool their individual
risks in a large group, and reduce or eliminate
their risks.
 Under ideal conditions the insurer has little or
no objective risk, due to the predictability of
losses arising from the law of large numbers.
 This process may be compared to an alliance of
a group of nations to ward off an attack.
Individually, each nation may have substantial
risk, but in a group the risk to each is reduced.
Combination of Objects Subject to Risk
 Large business organizations often have a
sufficiently large group of insurable objects so
that they can accurately predict loss
experience.
 From the loss experience data the firm makes
careful estimates of the funds needed to meet
these losses and lays aside funds for this
purpose. This method of handling risk is really
planned retention or self insurance.
Combination of Objects Subject to Risk
 The method of combination also has been used to
meet various types of uninsurable risk, such as the
risk of losing one’s market due to product
obsolescence, of loss due to labor strikes or actions
of competitors. The wave of business mergers in
recent years has been attributed in part to the
desire to reduce such market risk. Thus two or
more firms may combine into one for the purpose
of securing a more diversified product line, so that
in the event the sale of one product is unprofitable,
another might compensate for it. The uncertainty of
loss from one unprofitable line is thus reduced.
Risk Transfer or Shifting
 In the transfer or shifting method, one individual
pays another to assume a risk that the transferor
desires to escape. The risk bearer assumes the risk
for a price.
 The risk of loss is often the same to the transferee
as it was to the transferor.
 The risk bearer (transferee), however, may have
superior knowledge concerning the probability of
loss, and thus may be in a better financial position
to assume the risk than the transferor.
Nevertheless the risk still exists.
Risk Transfer or Shifting
 Difference between transfer method of handling
risk with the combination method is that in the
transfer method the risk is not necessarily reduced
or eliminated, whereas in the combination method,
the risk is actually greatly reduced or perhaps
completely eliminated.
Risk Transfer or Shifting
 Example: A furniture retailer may not wish to stock
large quantities of furniture for fear that price may
fall before the stock can be sold, or stock may be
un saleable due to style changes. The retailer
therefore buys only limited quantities of goods at a
time, thus forcing a wholesaler to carry sufficient
inventories to meet demand. The wholesaler in this
case is the bearer of risk of loss due to price
changes. The wholesaler may in turn attempt to
shift the risk to the manufacturer.
Risk Transfer or Shifting
 Insurance companies often operate as transferees
of risk instead of using combination method, simply
it is impossible to obtain a sufficiently large number
of exposure units to allow the law of large numbers
to operate.
 Example: ICICI Prudential accepts an insurance
contract covering the loss of the hands of a famous
pianist, it is acting in the capacity of a risk
transferee, not as an agent to pool the risk of large
number of pianists.
Risk Transfer or Shifting
 In commercial insurance operations, it is often
difficult to tell when the combination method ends
and transfer method begins, for there are many
instances in which an insurance concern has an
insufficient number of exposure units to obtain
extremely accurate predictions of loss experience.
In these cases, the insurance companies act as
transferees and the risk is not necessarily reduced.
Risk Transfer or Shifting
 Other examples are bankruptcy and leasing. A
person or a business may voluntarily enter
bankruptcy, thus shifting to creditors the losses
that might be borne by bankrupt person. A person
who leases or rents property rather than owns its,
shifts to lessor the ownership risk. The cost of
shifting the risk is contained in rental payments.
Loss Control
 Loss control or loss prevention is not insurance but
it does usually reduce the degree of subjective risk.
 Loss prevention may actually increase the degree
of objective risk because it may reduce the
probability of loss.
 The less probable an event is, the greater the
relative dispersion of actual loss to expected loss.
Risk Avoidance
 Avoidance is avoiding risk.
 The method of avoidance is widely used particularly
by those with high aversion towards risk.
 Example: A person may not enter a certain
business at all and avoid the risk of losing capital in
that business. A person may not use airplanes and
thus avoid risk of dying in an airplane crash.
Managing Subjective Risk
There are three possible ways to problems raised
by existence of subjective risk:
1. Through more information.
2. Group Discussion.
3. Training & Education.
Search for Information
 Major way of handling subjective risk is by adding
knowledge through research.
 A risk averter may be more willing to accept risk
once there is better understanding of uncertainties
because with better knowledge one is likely to
perceive less risk in the situation.
 A risk taking person may be willing to assume
greater risks as his knowledge increases.
 As insurers gain more experience in a given line,
they very often become willing to insure risks they
formerly rejected and at reduced premiums.
Group Discussion
 Research has established that perceived subjective
risk declines after group discussion of the problem.
 Example: Underwriting committee discussion may
provide more liberal underwriting with less
perceived risk by the insurer.
Training & Education
 Education in risk & insurance may improve
efficiency with which insurance is employed by
making the user a more sophisticated buyer.
 When the buyer really understands sound
principles of insurance, premium money is more
likely to be spent to cover serious loss exposure.