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what is speculative risk

Why Manage Risks?

There are many reasons for managing risk. Here are some:

  • Saves resources: people, income, property, assets, time
  • Protects public image
  • Protects people from harm
  • Prevents/reduces legal liability
  • Protects the environment

In every business, from the small corner store to the large manufacturer, there are common challenges with insurance, claims, and risk in general. Buildings can be damaged by fire; someone could slip and fall; vehicle accidents often occur; losses can occur as a result of defective products. These are just a few of the very many things that can go wrong.

Now, more than ever, it is vital to the success of an organization to understand risk management and to learn to control liability. With the world’ economic downturn¹ driving more claims activity² risk management has become the first line of defense³.

Contained below is all the information you need to understand the insurance market and to get you started with risk management. For an even more detailed understanding of the insurance market and risk management, download a free E-copy of Craig Rowe’s book Insurance Premiums Are Killing My Business! Controlling Insurance and Claims Costs for Small to Mid-Sized Business . Unless otherwise stated, all information contained in this text is from Craig Rowe’s book.

How Does Insurance Work

Insurance is a mystery to many people. Simply put, an insurance company pools the money of a large group and promises that if one of the group suffers a predefined loss, then the pool will pay for the loss.

Business owners and individuals trade off the affordable cost of insurance for the peace of mind that a large loss won’t mean financial ruin.

If an insurance company makes a profit before considering investment income, it is called an Underwriting Profit. The converse is an Underwriting Loss. It is called such because underwriting is the decision process of what to insure and for how much. If the underwriters do their job well, then the insurance company should be able to anticipate how much it will pay in claims and expenses, and charge a commensurate premium that allows for a profit. This, however, is rare.

Most insurance companies make their money in investment income. They take in large quantities of money in insurance premiums and invest it. They rely on the fact that there is usually a long time between when premiums are collected and when losses are paid. When insurer ROE(return on equity) is high, then insurers can take underwriting losses and still be quite profitable. When ROE is low, they look for higher premiums to recoup past losses and to pay for future losses.

When insurers go through a few years where claims are high and ROE is low, they raise rates to make up for past losses. Then, when they’ve had a few good years, they get competitive again and start lowering prices. After a few years they again feel the impact of the low premiums and high claims and have to raise premiums. And on the cycle goes!

When you are the one paying for these premiums it can get very frustrating and very difficult to budget for. Insurance rates can vary 100%, 200%, 300%, or even more from the top of the cycle to the bottom.

When you go to renew your policy, or shop around for other insurers, they look at your loss ratio. They consider the premiums you’ve paid compared to what you’ve cost them in claims. If you’ve had a good loss ratio, then in the long run you should achieve better terms and price. If you’ve had a bad loss ratio, then you may pay higher rates, have exclusions added, have limits reduced, have deductibles increased, or not be renewed. What constitutes an acceptable loss ratio depends on the insurance company, the type of business, and many other factors, but obviously the lower, the better!

It is important to note that insurers don’t have to insure your business. There may be some exceptions where regulators make it mandatory to insure certain types of risk, but this is rare. Since they don’t have to insure you, it is important to make sure you are one of the good risks that they want as part of their book of business.

All information contained in this text is from Craig Rowe’s book Insurance Premiums Are Killing My Business! Controlling Insurance and Claims Costs for Small to Mid-Sized Business (2003).

Factors Affecting Insurance Premiums

Factors Affecting Insurance Premiums

  1. Claims - generally, if your claims consistently cost the insurer more than the premium you pay, expect an increase.
  2. Industry - The type of business you are in affects your premiums.
  3. Loss Control - If your business has safeguards in place against loss then insurers will look at you more favorably. Sprinkler systems, alarm systems, safe driving policies, contractual risk transfer, etc. will all likely warrant premium savings.
  4. Operations/Processes - This covers a lot of ground, but essentially your business will be rated based on the types of processes you employ and the risks associated with them.
  5. Deductibles - You can, in most cases, have a choice in the deductibles on your policies. The general principle is: the higher the deductible, the lower the premium.
  6. Policy Limits - The amounts that you choose as your policy limits will affect your premium.
  7. Coverage - A lot of the coverages you have will be essential for your business. However, sometimes coverages are in places that are not required. It is a good idea to go through your policy with your broker every few years to identify any unnecessary coverages.
  8. Values Insured - Obviously, the higher your insured values, the higher your premium. Make sure your values are accurate.
  9. Risk Management - Insurers take into consideration the risk management of an organization in determining the premium. It probably won’t result in any specific discount, but an organization with strong risk management practices and a proven track record in managing risks will be looked upon more favorably by insurers.

All information contained in this text is from Craig Rowe’s book Insurance Premiums Are Killing My Business! Controlling Insurance and Claims Costs for Small to Mid-Sized Business (2003).

What is Risk Management?

Everyone knows what a risk is; we use the word everyday and we take risks regularly, whether we realize it or not. In every decision you make, when assessing the pros and cons, you are also doing a risk assessment. The challenge is to make it a more conscious process where your business is concerned.

A risk exists where there is an opportunity for a profit or a loss. In terms of losses, we commonly refer to the risks as exposures to loss, or simply exposures. A fire is an exposure. Defective products or defamation are liability exposures. The loss of business that results from a damaged building or tarnished reputation is also an exposure.

The extent of a risk can be expressed as follows:

Risk = Probability x Severity,

where Probability is the likelihood of an event occurring, and Severity is the extent and cost of the resulting loss.

Risk management is the process of making and carrying out decisions that will minimize the adverse effects of risk on an organization. The adverse affects of risk can be objective or quantifiable like insurance premiums and claims costs, or subjective and difficult to quantify such as damage to reputation or decreased productivity. By focusing attention on risk and committing the necessary resources to control and mitigate risk, a business will protect itself from uncertainty, reduce costs, and increase the likelihood of business continuity and success.

In broad terms, risks may be broken down into two categories:

  1. Pure Risk refers to those risks where the possible outcomes are loss or no loss. It includes things like fire loss, a building being burglarized, having an employee involved in a motor vehicle accident, etc.
  2. Speculative Risk refers to those risks where the possible outcomes are loss, profit, or status quo. It includes things like stock market investments and business decisions such as new product lines, new locations, etc.

All information contained in this text is from Craig Rowe’s book Insurance Premiums Are Killing My Business! Controlling Insurance and Claims Costs for Small to Mid-Sized Business (2003).

The Risk Management Process

  1. Identify Potential Exposures To Loss
  2. Measure Frequency and Severity
  3. Examine Alternatives
  4. Decide Which Alternatives To Use
  5. Implement The Chosen Techniques
  6. Monitor Results

Many businesses do things to prevent losses or mitigate risks everyday, but don’t think of it as risk management. Most prudent business people and managers take great care to do things like prevent accidents, protect property, and keep customers and employees from harm. Any effort to manage risks is positive. It is important, however, to follow a formal process to ensure consistency and thoroughness. The following are the essential elements of the risk management process.

Category: Forex

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