The previous four articles in the series of Understanding Insurance have laid a basic understanding of risk. Article number one, What is risk?, is defining risks and making arguments about the conservation of risk. The second article, Categorizing risks, sorts risks out into four categories based on a combination of frequency and severity. Several actions that we can take on these risks have also been introduced, namely to ignore, to retain and to transfer. Third article Holding hot potato: transfer or avoid further discusses risk transfer and associates it with insurance, then add the last option in managing risk i.e to avoid. Whereas the fourth article, How risks turn into loss? describes the process of risk transformation into loss which involves peril and hazard.
Before we continue the discussion, let’s summarize the risk categories and options to deal with them in the picture below:
Now, let’s discuss about Risk Management, which is the basic framework in dealing with risk, both for individuals and organizations. It includes three main steps namely identification, analysis/evaluation and actions/control, as summarized in the figure below.
The first step, risk identification, is essentially making a list of risks around us. The second step, evaluation or analysis, actually predicts how serious or severe the impact of each identified risk is. In other words, how much is the maximum financial loss may be suffered if the risk turns into a disaster.
After the second step, we may reorder the list of risks based on the severity or magnitude of the maximum loss it might bring. This information is certainly very useful in determining in which quadrants (see figure 1) these risks belong. It will lead us to determining the steps or actions we may take for each risk. Starting from ignoring to avoiding.
The choice to ignore is the extreme left, where we simply do nothing. Whereas, the avoidance is at the extreme right, as we take very drastic measures, such as eliminating sources of risk. A concrete example is when you have a car, then the various inherent risks such as a collision, theft, vanished by fire and so on, become yours too. When you decide to sell the car, all those risks automatically disappear.
Between these two extremes, there are several choices available to risk owners in managing their risks. The risks still exist, it’s just that the owner intervenes to control their impact, hence those actions called risk control. These interventions can be classified into physical risk control or financial risk control.
Under physical risk control, we have elimination and minimisation. Elimination is in principle avoidance that we discussed above, by which we are eliminating the source of risk. While minimization is doing certain action to reduce the impact of losses to a minimum. Wearing a seat belt when driving is an example.
Under financial risk control, there are retention, transfer and sharing. The option to retain can be done by simply treating financial losses as a cost to be absorbed by balance sheet, setting aside funds on a regular basis to anticipate losses (self-insurance) or in the case of a large corporation, it may establish a dedicated insurance company to manage risks in its business group (known as captive insurer).
As we can see in the framework of risk management (picture 2 above), (conventional) insurance is basically a method of transferring the financial consequences of risks to other parties, in this case the insurance company. Takaful, on the other hand, is also classified as financial risk control by which the risk owners share or collectively bear risk of one another.