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Risk Management in Business - Report Example

Summary
The report "Risk Management in Business" focuses on the critical analysis of the major issues in risk management in business. Risk is a condition where there is a possibility of an adverse deviation from the expected outcome. Pure risk only involves the possibility of loss or no loss…
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Extract of sample "Risk Management in Business"

Name Student Number Lecturer Campus Date Question 1 Risk is a condition where there is a possibility of an adverse deviation from the expected outcome. Pure risk, on the other hand, is a risk that only involves the possibility of loss or no loss (Donnie 2000). Insurers do not insure just any risk. Since this is a business, they must ensure that they minimise their risks and, therefore, there are some requirements that a pure risk must meet for them to accept to insure. One of the requirements is that there must be a large number of similar exposure units. Insurers minimise their risk of loss by complying with the law of large numbers. It states that there must be a large number of exposure units independently exposed to risk of loss. There are some exceptions to this law (Taylor 2004). Insurers taking large property insurance policies may insure only a few properties. This is because the properties are very expensive and having many units will concentrate risks. The most important thing in this case is for units to be many but independent. Insurers also require that these units face specific risks. These risks are called specialised risks Lloyd’s of London insurance and reinsurance market has members with a large number of similar exposure units coming together to spread risks. Insurers require that when risk occurs, there must be accidental losses. If there is possibility of compensation for loss that has occurred in an intentional manner, then some people may take advantage of this and cause loss intentionally. Insurers will suffer a great loss if this happens. Possibility of losses occurring should not be certain but accidental. If insurers are able to predict the occurrence of the loss, they may set high premiums to ensure they make high profits before the loss occurs and payments made (Culp 2002). The moral hazard in premium determination for an insurer is low. Therefore, future prediction of losses will be not possible. The risk insured must be determinable and measurable. Being determinable implies that risk should be verifiable as to cause of occurrence, time of occurrence and place of occurrence. Upon the occurrence of the risk, the insured may have emotional distress that may have an economic impact. This economic value should be measurable (Gabriel 2003). If, for example, livestock is insured and loss occurred, then the economic effect arising from the loss and emotional distress should be measurable. Loss arising from the occurrence of risk should not be catastrophic. Although occurrence of loss should be determinable, if it is catastrophic, then the insurer will suffer a big loss. Risk pooling is the process of bringing together many units that face common risks under one insurer. This brings dependent exposure units under one insurer. On the event of risk occurrence, the loss would be too big. Insurer should take control measures to avoid this situation. These measures are reinsurance and avoiding concentrating risks. The insurer should only concentrate on a single risk. Reinsurance is the process which insurers take insurance cover form other insurance companies as a method of risk management. On the other hand, for insurers to avoid risk concentration, they deal with specific risks. In addition, they ensure that the value of the units insured is an amount that they can pay according to their budget. Chance of loss occurrence should be calculable. It is important that insured’s economic loss be ascertainable because the purpose of insurance is to reduce or eliminate uncertainty of economic loss (Lash 2002). Before insuring any unit, insurers calculate the frequency of loss occurrence and the severity of future loss as well. Whenever they are unable to calculate these elements, then they do not insure the risk. Predictability of future losses should also be calculable. Insurers must set premium rates economically feasible. Policyholders should be paying an amount relevant to the size of loss significance. This is to ensure that the insurer does not exploit them. However, this amount should be small in comparison with possible loss. Question 2 General insurance market undergoes an underwriting cycle between hard and soft market conditions. This is a cyclical manner in which profits within the market tend to rise and fall within a certain period (Meir 2006). The hard market condition occurs when profits are high while soft market conditions occur when profits are low. One condition triggers situations that lead to the other. In the hard market condition, insurers raise premium rates making policyholders pay higher amounts. The terms and conditions set for policies in the market tighten. Insurers have lower limits. With this, profitability, within the market becomes very high. It becomes very attractive for investors. Additional capital flows in the market to benefit from the high profits existing. This may be from new insurers entering the market or existing insurers who desire to have a larger market shares. Stiff competition results in the market with each insurer desiring to attract more customers and make higher profits. The supply in the market becomes too much and may supersede the demand. The soft market condition falls into place because of these conditions existing in the market. High competition makes insurers reduce premium rates. Terms and conditions of policies in the market become relaxed. The insurer has higher limits in the market. With insurers receiving low premiums, the market becomes unprofitable and unattractive for investment. Capital exits the market as some insurers opt to leave the market while others reduce the amount of business they are writing in it. Competition in the market therefore, greatly reduces because very few players will remain. Supply of insurance service in the market contracts and the demand may be greater. Insurers left in the market raises premiums rate to increase their profits. Increase in profits leads to another cycle. Some factors affect the length of a cycle hence making cycles vary. The class of business and the geographical location are the main factors (John 2008). Question 3 A) Trauma insurance intends to pay out if an individual suffers a critical illness or become incapacitated. In this policy, there are premiums that are not tax-deductible. In this case, proceeds are tax-free. The occurrence of a loss may mean that a policyholder has no income. This premium’s purpose is to replace income that they have not earned due to trauma. On the other hand, there are premiums that are tax deductible. Proceeds in this case are taxable. The tax rate when taxing is at 12%. There is a general exemption of capital gain tax (CGT) from proceedings of this policy. This is because the policyholder has no income and proceeds will be the income. However, benefits paid to other person than the insured, CGT will apply. Surrender value of this policy is included for cenrelink. When employers pay premiums for their employees, fringe benefits tax apply. In this case, premiums are tax deductible for the employer. Employee’s assessable income will not include these premiums. B) A key person is an individual with specialised knowledge, skill or expertise and is vital to the success of a business. Employers choose the policy to take depending on specific needs of their business. Key person insurance policy is taken by employers to cover losses that would occur if an employee who contributes to the profits of the business were lost for one reason or another. Policyholders may take this insurance cover for either capital or revenue purposes. If taken for capital purposes, then premiums are not tax deductible. In this case, payments are also not taxable. If a business meets certain principles in key person insurance, premiums paid may be tax deductible. The premiums are treated as allowable business expenses, which imply that they are offset against profits that the business has made during taxation. The first principle is that the relationship between the business and the key person should be that of employer and employee. If the key person has stake in the business, then premiums are not tax deductible. Another principle is that the life policy should intend to meet loss that the businesses will suffer because of losing the key person. If the policy covers any other losses, then premiums are not tax deductible. The third principle is that the policy is a short-term assurance. In most cases, the time allowed is five years. No premiums beyond the short-term are tax deductible. These principles are known as Anderson rules. Employers may take key person insurance to cover all work related accidents or all nonwork related accidents for their employees. Employees may also take this policy to cover any accidents whether work related or not. In the later case, premiums are not tax deductible. C) The ten years rule in an insurance policy restarts at different circumstances depending on the time of cashing of the reversionary bonuses from time of commencement. The policy holders in life insurance receive reversionary bonuses from the time of commencement of the policy and may cash it at any time. Cashing of the bonuses before eight years of commencement makes them taxable in full rate. The tax rate is at 30%. Taxation of bonuses received and cashed during the ninth year of commencement is not in full rate. Instead, taxation is at twothirds of the full rate. Those received in the tenth year from commencement are only taxable at one-third. After the tenth year of commencement, bonuses will be tax-free D) Policyholders with superannuation plan in life insurance death benefits contribute premiums from earnings. Either employers or employees may do this. One advantage of this plan is that it is cheap because the funds contributed are able to buy bulk and therefore policyholders can negotiate for lower premium rates. This plan is also tax effective because premiums are made from contributions. In this plan of life insurance, there are two factors governing taxation. They are; taxation dependent superannuation, which is tax-free and nondependent superannuation. In the later case, two components are considered; there are those taxable and others tax exempt. Employers may be contributing premiums for employees under employer-sponsored group insurance. Employers receive proceeds of death benefits from insurer when death of employee occurs. Payments made are as employment termination payments. In these payments, there are two components involved; life benefits termination payments and death benefits termination payments. In death benefits termination payments, tax consequence will depend on two factors. These are whether benefits proceeds will go to dependents or to non-dependent. Payments to dependent are tax-free, but to non-dependent are taxable. Question 4 In life insurance rate is the price per unit of insurance for exposure. Ratemaking, also called insurance pricing, is the process that actuaries determine rate or premiums to charge in insurance. It is possible to purchase life insurance policies with a single premium. This is however very expensive for policyholders and many people opt to buy with annual, semi annual, quarterly or monthly basis. The net single premium payable for a policy forms the basis of ratemaking. The net single premium is the present value of the future death benefit. In ratemaking, the first risk to consider is mortality risk. This is the risk of death of the policyholder. Insurance companies operate as businesses with an aim of making profits. Rate payments must therefore, consider this to ensure that there will be profits. Actuaries determine life expectancy of different categories of policyholders by using mortality tables. These tables show the number of deaths for each age in a general population of many people. The rate charged must cover loss due to death and still earn profits for insurers. Ratemaking also functions to cover expense risk. For insurers to be successful in their business, premiums that they receive should also cover expenses and allow them to make profits. When risk covered in life insurance occurs, policyholders will receive proceeds to cover all expenses that will occur. Policyholders take life insurance policies as investments. This results to investment earning risks for the insurer. The function of ratemaking is to cover this risk and leave profits for insurer. REFERENCES Brown, R. (2007). Introduction to ratemaking and loss reserving for property and casualty insurance. Winsted, Conn: ACTEX Publications. Culp, C. (2002). The art of risk management: alternative risk transfer, capital structure, and the convergence of insurance and capital markets. New York: J. Wiley. Dionne, G. (2000). Handbook of Insurance. Springer: Kluwer Academic. Gabriel, V (2003). Management. Singapore: Longman. John Wiley. (2008). Encyclopedia of quantitative risk analysis and assessment. Chichester, West Sussex, England Hoboken. Lash, V. (2002). Insurable interest. Baltimore: Trimble & Durst. Meier, U. (2006). Existence and causes of insurance cycles in different countries: four empirical contributions. Bern Stuttgart Wien: Haupt. Taylor, J. (2004). Managing information technology projects : applying project management strategies to software, hardware, and integration initiatives. New York: AMACOM. Read More

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