# INSURANCE AND RISK MANAGEMENT IRM EXAMINATION

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```					       SUGGESTED ANSWERS DIRM TECHNICAL EXAMINATION MAY 2008
PAPER – 3 (RISK MANAGEMENT AND REINSURANCE)

1. Choose the correct answer to the following:
(i) The cause of loss is defined as:
(a) Uncertainty
(b) Hazard
(c) Peril
(d) Risk
Ans: (c ) Peril

(ii) When there is Robbery in Horizon Bank and it lost 1 crore, it is a case of:
(a) Fundamental risk
(b) Particular risk
(c) Bank risk
(d) Dynamic risk
(e) None of the above
Ans: (b) Particular risk

(iii) Defective wiring in a Cinema Hall which increases the change of fire is an example
Of
(a) Risk
(b) Peril
(c) Moral Hazard
(d) Physical hazard
(e) None of the above
Ans: (d) Physical hazard

(iv) Making use of matrix plotting in loss frequency and loss severity is known as
(a) Risk analysis
(b) Risk grid
(c) Risk mapping
(d) Risk convergence
(e) None of the above
Ans: (c) Risk Mapping

(v) The approaches used for risk identification include use of
(a) Loss exposure check list
(b) Flow charts
(c) Statistical analysis of Historical data
(d) Analysis of Financial statements
(e) None of the above
Ans: (e) None of the above

(vi) Given that P1 = 0.25, P2 = 0.55 P3 = 0.20 and X1 = 15,000, X2 = 20,000 and X3 = 8,000
respectively, what is the expected value of the coordination of above values.
(a) 17,350
(b) 18,750
(c) 16,350
(d) None of the above
Ans: (c ) 16,350
(vii) Which of the following is not a form of Risk Transfer?
(a) Hold harmless agreements
(b) Incorporation
(c) Partnership
(d) Insurance
(e) None of the above
Ans: (c ) Partnership

(viii) The basis of Modern Insurance theory is
(a) Law of Large numbers
(b) Theory of Probability
(c) Utility theory
(d) All the above
(e) None of the above
Ans: (d ) All the above

(ix) The form of excess of loss insurance which indemnifies the reinsured against the amount by
which the reinsured losses incurred during a specific period exceed either an agreed amount
or agreed percentage is called
(a) Stop Loss reinsurance
(b) Excess of Loss reinsurance
(c) Quota share reinsurance
(d) Proportional reinsurance
(e) None of the above
Ans: (a) Stop Loss reinsurance

(a) Take as much reinsurance as possible
(b) The reinsurer is normally bound by the primary insruer’s action in the underwriting and
claim matters
(c) The reinsurer need to follow the reinsurance rules and not primary insurer’s actions
(d) a and b
(e) None of the above
Ans: (b) The reinsurer is normally bound by the primary insurer’s actions in the
underwriting and claim matters

(xi) The Indian Reinsurance agency is
(a) Exim Bank
(b) ECGC
(c) GIC
(d) LIC
(e) IRDA
Ans: (c ) GIC

(xii) “Probable maximum loss” is an assessment by
(a) The cedent
(b) The reinsurer
(c) The surveyor
(d) The broker
(e) None of the above
Ans: (c ) the surveyor
(xiii) Tax concessions by the local governments are a major attraction to
(a) in-house insurance
(b) self-insurance
(c) captives
(d) private agencies
(e) None of the above
Ans: (c ) captives

(xiv) The Principal purpose of an excess of loss treaty is to
(a) Stabilise loss exposures
(b) Providing large line capacity
(c) Stabilise earnings
(d) a and b
(e) a, b and c
Ans: (d) a and b

(xv) Setting reinsurance limits depends on
(a) Company considerations
(b) Cost considerations
(c) Financial strength of the reinsurer
(d) Financial strength of the client
(e) None of the above
Ans: (b) Cost considerations

(xvi) In facultative reinsurance negotiations, one of the following is important
(a) the Reinsurer
(b) the Primary insurer
(c) details of individual loss exposure
(d) underwriting operations
(e) None of the above
Ans: (c ) details of individual loss exposures

(xvii) The premium registered in the books of an insurer at the time a policy is issued is called.
(e) None of the above

(xviii) Law of Large Numbers is not applicable in one of the following cases.
(a) Motor Insurance
(b) Catastrophes
(c) Marine Insurance
(d) Life Insurance
(e) None of the above
Ans: (b) Catastrophes

(xix)Which of the following clauses allows the reinsured to effect other reinsurances in priority?
(a) Recital clause
(b) Records clause
(c) Operative clause
(d) Net retained lines clause
(e) None of the above
Ans: (d) Net retained lines clause

(xx) One of the following insurances is based on spreading risk over time
(a) Financial Insurance
(b) Infinite Risk Insurance
(c) Finite Risk Insurance
(d) Time Risk Insurance
(e) None of the above
Ans: (c ) Finite Risk Insurance

2. (a) What is Hazard? Explain different Hazards..

ANS:
A condition that creates the chance of loss or increases the chance of a loss is termed a
‘hazard’. Three major types of hazards are usually distinguished.
a.   Physical hazard
b.   Moral hazard and
c.   Morale hazard
Physical hazard : A physical condition that increases the chance of loss such as defective
electrical wiring, bad and poorly maintained roads, defective locking system etc. which may
increase the chance of fire, motor accident, theft respectively.
Moral Hazard : Moral hazard is a condition characterized by defects in the character of an
individual. For example: making a fraudulent insurance claim, submitting an insurance
claim for an inflated amount and setting fire to an insured godown containing old / scrap
stock.
Morale Hazard : Morale hazard refers to carelessness or indifference to loss (because of
availability of insurance) which will increase the loss. For example: Leaving car keys in an
unlocked car door.

(a) Explain the term adverse selection and what steps the insurance companies need to take to
Ans:
Problems of Adverse Selection: This problem arises when the customer knows his situation
better than the seller of insurance. The problem of adverse selection is common in insurance
markets all over the world. By withholding some vital information regarding their
insurability, some of the insured may be able to obtain favourable prices and terms and
conditions. To fix a fair premium that reflects the expected value of the losses of the
potential insured, the insurer must have full and relevant information about the insured.
The underwriter has to use his/her underwriting skills to judge the risk and properly rate it

3. (a) Give briefly the concept of Probability How it is useful in the risk management process.
Ans:

The numerical evaluation of chance factor of an event is known as probability. The
probability of occurrence of an event say a fire accident is the same as the chance of loss
(due to fire). For computing the probability of an event, the number of times a specific
event occurs is divided by all possible events of that type. If 30 accidents are observed to
have occurred to 6000 ears in operations in a town during a given time period say a year, we
can say that there is a probability of 0.005 of accident.

Probability concepts are of great value in the risk management process such as analyzing
accident frequency and severity rates, determining the reasonableness of insurance
premium or the adequacy of reserves established for risk retention, and selecting from
alternative risk management techniques on the organisation’s profit. The probability
distributions assist in predicting future losses.

(b) Find Mean, Median and Mode of the following:
46, 57, 75, 67, 86, 95, 52, 57, 71,98 and 57

Ans: Mean     = ΣX i = 761 / 11 = 69.18
n
Median = Arrange in increasing or decreasing order and mid value is
median
46, 52, 57, 57, 57, 67, 71, 75, 86, 95, 98
= Median = 67
Mode = the most repeated value which is = 57

(c ) What are the measures of Dispersion?

Ans: The measures of dispersion measure how the data is dispersed or spread out.
Variation from what is expected denotes risk. Following are the measures of dispersion.

i) Standard Deviation
ii) Variance
iii) Coefficient of Variation

(i) Standard deviation is a number that measures how close or distant a group of individual
measurements is to its expected value.
(ii) Variance is the square of standard deviation
(iii) coefficient of variation: Percentage of standard deviation to the mean

4. (a) What is expected utility rule in Insurance?

Ans:
The application of the expected utility rule in insurance is useful whether an individual will
purchase insurance in order to minimize uncertainty. By purchasing insurance policy, one
pays a premium to avoid a risky outcome. Thus the purchase of an insurance policy
involves the sacrifice of certain wealth in order to avoid the possibility of a loss of wealth.

(b) Name the various economic theories of Consumption.

Ans: The various economic theories of consumption are
(i)    Absolute income hypothesis
(ii)   Relative income hypothesis
(iii) Life cycle hypothesis and
(iv)   Permanent income hypothesis
The economic theories of consumption assume that rational consumers seek to maximize
their lifetime utilities while allocating income between current consumption and future
consumption or saving. This assumption implies that individuals divide their income
between current consumption and future consumption in a manner that results in
optimizing their pattern of consumption over life time.

(c ) What is Endowment effect according to behavioural economists?

Ans: It describes the tendency of people to set a higher selling price on an item that they
own or endowed with than what they would be willing to pay to purchase an identical item
if they did not own it. The endowment effect has been found to have a powerful influence on
investment decisions that could not be explained by the rational investor model. This has
been put forward by Richard Thaler in order to explain financial behaviour that seems
inconsistent with utility theory.
(d) Name the two characteristics of utility function for a risk averse individual exhibit.

Ans: A utility function for a risk-averse individual exhibits the following two
characteristics.

1. More wealth is preferred to less wealth. Increasing wealth gives increasing levels of
satisfaction; and

2. The incremental utility or satisfaction from unit increases in wealth decreases as wealth
increase i.e. for a poor person an addition of Rs. 1000 of wealth will make a great impact
than the same increase of wealth to a rich person.

5. (a) Explain the process of evaluation of Potential risk.
Ans:
Subsequent to identification of risk, the second step in the risk management process relates
to analyzing, evaluating and measuring the impact of losses on the individual or corporate
unit by estimating the potential frequency and severity of losses. While frequency of loss
relates to the probable number of particular losses that may occur during some given
period of time, severity of loss refers to the probable magnitude of losses that may occur, if
they occur. This will enable ranking of various loss exposures according totheir relative
importance. Though both frequency and severity of a loss have to be considered in risk
management process, severity of course is of more importance. It is helpful in estimating
maximum probable loss from the occurrence of an event.

(b) Outline appropriate techniques of Risk Financing.
Ans:
Risk Financing :This covers all methods employed to fund either the probability of loss–
producing events occurring or the potential size of losers that do occur. For example installation
of fire extinguishers to minimize loss in case of fire. The methods are:
i)    Risk Retention: Retention refers to the financing of losses internally – either fully
retained or partially retained. Losses that occur when prior planning for their financing
has been done are also retained. Retention is resorted to when no other risk
management treatment is available like when insuance coverage is not available or
very expensive. Further, non-insurance transfer may be unavaila-ble. Thus, retention
may in fact be a residual method. Retention can be effectively used when the potential
losses are highly predictable. It is also said that “the more risk averse the less the
retention”.
ii)   Insurance: Commercial insurance is a technique of transferring risk from one party
(individual or business) for whom the risk is costly to another party who is willing and
is able to bear the risk. Insurance is thus one of a number of available instruments for
hedging risk. It is an instrument for post loss financing. Own medical insurance is an
appropriate strategy for controlling loss exposures that have a high severity of loss
coupled with a low probability of loss
iii) Non-Insurance Transfers: They are techniques (other than insurance) by which a
risk exposure and its potential financial losses are transferred to another party who is
in a better position to exercise loss control. A number of instances of non-insurance
transfers can be cited. A compute lease agreement by a firm may contain a clause to
the effect that maintenance, repairs etc., of the computer are the responsibility of the
computer firm. A publishing firm may specify that the author and not the publisher are
legally liable for plagiarism, if any.
iv) Combination: This method takes advantage of the law of large numbers. One can
combine a large number of independent exposure units in one portfolio; an insurance
company is able to reduce the risk of its aggregate losses. The best example would be
in the case of a large group which by centrally pooling the risk of breakage of its shop
windows could predict annual losses within narrow limits.
v)    Hedging: Firms that enter into contracts to supply goods at a fixed price in the future
face the risk that a rise in prices between entering into the contract and the delivery
date may involve them in a loss. Hedging gives protection to the seller for Indian
importers by allows in them to forward purchase specific foreign currencies. Thus
regardless of the exchange rate the importer’s liability will be limited to the cost of
vi) Research: this is done to improve the information on which decisions are taken can
help to reduce risk. For example when marketing a new product may go for market
research to reduce uncertainty.

6. (a) Write short notes on any four of the following:

(i) Pure Vs. Specualative risks
(ii) Product differentiation
(iii)New Risk transfer tools
(iv)Derivatives
(v) Inward reinsurance
Ans:
(i) Pure vs. Speculative risks
Ans: Pure risks are those risks, the occurrence of which are likely to cause a loss to an
individual or an organization with no possibility of gain. The examples of pure risks are
risk of fire, risk of flood, earthquake, legal liability risk etc.
Speculative risk is present when an event can result in either a gain or a loss or status
quo. Examples of situations involving speculative risk include individual’s decisions to
in real estate etc.
While insurance companies basically insure pure risks, speculative risks are generally
not considered for insurance.
Law of large numbers can be easily applied to pure risks; speculative risks, however are
not easily amenable to application of law of large numbers.
(ii)Product differentiation

Ans: Market power is said to exist in the market if an insurance company can differentiate
its products from those of its competitors in the minds of its customers. Product
differentiation is said to exist if buyers prefer the products of a firm over those of its
competitors. The differences between products need not be real; The customers have
to perceive difference in product quality, convenience, service, market reputation etc.,
Insurers all over the world try to differentiate their products from those of other
insurers in respect of provision of riders, after sales service, conferring additional
benefits etc.
(iii) New Risk transfer tools

Ans: During the last decade a number of new risk transfer tools have developed, although not
widely used in India. They are
a) Creation of captive insurance companies
b) Finite risk insurance
c) Multi-live / multi-year insurance contracts
d) Multiple-Trigger contracts
e) Securitisation
(iv) Derivatives
Ans: Derivatives are latest financial instruments that are derived from other instruments.
Futures, Forwards, Swaps and Options are various derivative instruments which play
crucial role in the risk management.
These instruments are used for managing financial risks such as interest rate risk,
commodity price risk, foreign exchange risk etc.
(v) Inward reinsurance
Ans: Inward reinsurance business is defined as the insurance business taken up by a direct
insurer or reinsurer from the cedent in turn for share in the premium volume generated by
the cedent or on a fee basis. The growing reinsurance market gave new hopes for many
reinsurance business along with their main line of business. A the market for inward
reinsurance is giving attractive returns many kind of companies all over the globe are
jumping into inward reinsurance business. However they need to have upto date market
knowledge research facilities etc.
7. (a) List out the essential aspects of a Reinsurance contract
Ans:
ESSENTIAL ASPECTS OF A REINSURANCE CONTRACT:
a) Contract of Reinsurance is a contract of insurance.
b) It is a separate contract distinct from original contract of insurance.
c) It is a contract of indemnity on the same risk as the original contract of insurance.
d) Both contracts are in existence at the same time.
These, however, can be modified during negotiations between insurer and reinsurer.
(b) Enumerate the main types of Reinsurance arrangements.
Ans:
TYPES OF REINSURANCE ARRANGEMENTS
1. Proportional treaties
2. Non proportional treaties
3. Facultative / Obligatory.
4. Financial Reinsurances
(c ) Distinguish between Coinsurance and Reinsurance
Ans:
Coinsurance                                         Reinsurance
i) It is a system whereby one insurer shares i) This is insurance of an insured risk where
direct risk with one (or) more insurance original insurer retains a part and cedes
companies                                    balance to the reinsurers
ii) Each Co’s liability is limited to the share ii) This is done to ensure greater spread and
amount mentioned in the policy                  reduce liability on the original insurer
iii) This is used mainly for covering big risks iii) This is governed by a pre-approved
/ mega projects                                 policy and elaborate IRDA regulations.

8. (a) State the important provisions of clause 3- IRDA regulations on reinsurance.
Ans:
Clause 3-2:Every insurer shall maintain the maximum possible retention commensurate
with its financial strength and volume of business.
Clause 3-3:Every insurer shall cede such percentage of the sum insured on each policy for
different classes of insurance written in India to the Indian reinsurer.
Clause 3-4: Every insurer shall submit to the IRDA his reinsurance programmes for the
forthcoming year.
Clause 3-5:Within 30 days of the commencement of the financial year, every insurer shall
file with the IRDA a photocopy of every reinsurance treaty slip.
Clause 3-6:IRDA may call for further information or explanations in respect of the
reinsurance program of an insurer and may issue necessary directions.
Clause 3-7: Insurers will place their reinsurance business outside India with specific related
reinsurers. Placements with any other reinsurer shall require the approval of the IRDA.
Clause 3-8:The Indian reinsurer shall organize domestic pools for reinsurance surpluses in
fire, marine hull and other classes in consultation with all insurers on basis, limits, and
terms which are fair to all insurers.;
Clause 3-10:Every insurer shall offer an opportunity to other Indian insurers including the
Indian reinsurer to participate in its facultative and treaty surpluses before placement of
such cessions outside India.
((b) Explain the role of Reinsurance Brokers
Ans:
Just as there may be brokers for primary insurers who act as intermediaries between the
insured and the insurer, there are reinsurance brokers who are go-betweens to primary and
reinsurers. The percentage commission paid by the reinsurers to the reinsurance brokers is
relatively small, compared to the commission paid to the insurance brokers and is
sometimes as low as one percent of the reinsurance premium.
When there are reinsurance brokers, the premium payments and loss payments as well as
premium refunds pass through them. When primary insurers do not have expertise to place
reinsurance directly, they need the services of the reinsurance brokers. Large reinsurers
also use reinsurance brokers as a matter of course. However, if primary insurers go direct
to reinsurers, they may be able to reduce the reinsurance cost to some extent.
The reinsurance brokers get their commission from reinsurers; they have a duty to reveal
the reinsurers all material facts concerning the risks, which they have obtained from the
primary insurers. The market share of reinsurance through reinsurance brokers in United
States is 75% which shows the predominance of reinsurance brokers in the reinsurance
market.
Generally reinsurance brokers handle treaty reinsurance in preference to facultative
reinsurance.
9. (a) ABC insurers are retaining the following amounts in commercial property account and
enter a five line first surplus treaty and six line second surplus treaty. The company’s retention is
Rs. 2,00,00,000 on any risk. The sum insured for various risks are as follows:
Rs.
Risk 1                                    8,00,00,000
Risk 2                                    7,00,00,000
Risk 3                                  11,00,00,000
Risk 4                                  16,00,00,000
Risk 5                                  32,00,00,000
Calculate the cession under 1st surplus and second surplus treaty for each risk.
Ans:
Risk No.            Sum Insured          Retention           1st surplus             2nd surplus
5 line                  6 line
1.                  8,00,00,000          2,00,00,000         6,00,00,000                 -
2.                  7,00,00,000          2,00,00,000         5,00,00,000             -
3.                  11,00,00,000         2,00,00,000         9,00,00,000             -
4.                  16,00,00,000         2,00,00,000         10,00,00,000            4,00,00,000
5.                  32,00,00,000         2,00,00,000         10,00,00,000            12,00,00,000

8,00,00,000      Surplus       not      covered        has      to      be         covered     under
facultative insurance
b) Consider an excess of loss cover paying 30,00,000 excess of 20,00,000 with provision of two
reinstalments at 60% of final earned premium. A loss of 90,000 was recovered. Calculate
reinstalment premium payable to the reinsurer. Earned premium is 65,000 for the year.
Ans: Reinstalment premium payable to the reinsurer.
90,000 (loss) / 30,00,000 (cover limit) x 65,000 x 60 / 100 = Rs. 1170/-
10. (a) Briefly explain some of the considerations to be kept in mind while finalizing the inward
reinsurance program for one year.
Ans: Some of the considerations the company should keep in mind while finalizing its
inward programme for the year is as follows:
(i) Treaty or Facultative – facultative involves more administrative work as each offer
has to be scrutinized. Treaty is less expensive but requires a thorough knowledge of
the market and treaty clauses.
(ii) Territorial scope – the political and economic conditions of the country has to be
viewed.
(iii) Direct or through brokers – if the company has experienced staff direct business can
be solicited. However this will involve travel expenses to procure business. So
initially it is better to place business through a broker.
(iv) Class of business – the company should decide whether it wants to underwrite
(v) Acceptance limits – Keeping in mind the financial standing and premium income of
the company, the acceptance limit should be large enough to make it attractive for
the brokers and ceding companies to offer business.
(b) Cost of Reinsurance is an important element in finalizing reinsurance deal. Explain the cost
of reinsurance.
Ans: The reinsurance cost includes the premium paid to the reinsurer and the losses
recovered or to be recovered under the reinsurance agreement. A primary insurer should
pay its own losses and the reinsurer’s expenses and profit under any treaty, if the treaty is
continued over a fairly long period. That is why the amount included in the premium for
the reinsurer’s expenses and profit is an important factor in assessing the reinsurance cost.
Loss of investment income may be greater under a pro-rata treaty than under the excess
treaty since the reinsurance premium for a pro-rata treaty is usually greater. Thus, the loss
of investment income may also become an additional cost of reinsurance. The cost of
administering the reinsurance program varies depending upon the type of reinsurance.
The cost of administering the reinsurance program varies depending upon the type of
reinsurance. The profit or loss on insurance assumed under reciprocal arrangement must
also form part of the reinsurance cost.
11. (a) Explain the method of rating in excess of loss cover by using Burning cost method and
Ans: One concept which is frequently used in calculation of rate for excess of loss covers is
Burning cost. The ratio of actual past losses to their corresponding premium for the same
period. This ratio is used in assessing a portfolio of business and in determining rate of
premium for renewal. This can also be termed as experience rating. The burning cost will
give the rate of premium, which is just sufficient to cover the losses suffered by the
reinsurers. This is then loaded by underwriter for a reserve in case of worsening of loss
normally used is 100/70 or 100/80.
GNPI – Gross Net Premium Income is the usual            per excess of loss reinsurance. It
represents the earned premium of the primary company for the lines of business covered
net, meaning after cancellation, refunds, and premiums paid for any reinsurance protecting
the cover being rated and gross meaning before deducting the premium for the cover being
rated.
In an excess of loss cover, the rate of premium is loading factor say 100/70th of average
burning cost of incurred claims per the current and previous years. Rate is applied to
GNPI.
b) In an excess of loss cover, the rate is 100/70th of average burning cost of incurred claims for
the current year and previous years, subject to a minimum of 1% and minimum of 3%. Rate to be
applied on GNPI. Calculate the premium for the year 2007 from the following data:

Year                             GNPI Rs.                         Incurred Loss Rs.
2004                             40,00,000                        80,000
2005                             60,00,000                        70,000
2006                             80,00,000                        1,20,000
2007                            1,20,00,000                   90,000
Ans: Solution
1                 2                   3                4               5
Year              GNPI                Incurred Loss    BC 3/2 x 100    Loaded
BC 100/70
2004              40,00,000           80,000           2.00            2.86
2005              60,00,000           70,000           1.17            1.67
2006              80,00,000           1,20,000         1.50            2.14
2007              1,20,00,000         90,000           .75             1.07
3,00,00,000         3,60,000         1.20            1.71
Hence the rate of premium would be = 1.71%.
Excess of Loss Premium payable for the year 2007 = Rs. 6,00,000

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