Definition of Risk
The concept of risk is fundamental in any discussion of employee benefit planning. For our purposes, risk will mean uncertainty with respect to possible loss. In other words, it is the inability to determine a future loss and to figure out how expensive it will be should the loss take place. For example, individuals have very little ability to know when they will die, become ill, disabled, or unemployed. All the typical potential losses associated with employee benefits are "risks" from the standpoint of the individual. Loss is meant to convey any decrease in value suffered. A hospital bill associated with an illness could result in a loss, because it would cause a decrease in the value of assets held by a person.
Peril and Hazard Distinguished from Risk
The concept of risk is different from the concepts of peril and hazard, but the three have an interrelationship. Peril and hazard are insurance terms, used primarily in property and liability insurance but also in life and health insurance. They also have considerable application in employee benefit planning.
A peril is defined as the cause of personal or property loss, destruction, or damage. Common perils involving property are fires, floods, earthquakes, thefts, and burglaries. These same perils also can cause personal harm. Other perils that cause personal losses are illnesses, bodily injuries, and death. A number of insurance policies are identified by the perils covered. Life insurance and health policies normally do not name the perils but usually cover all perils associated with those policies. Actually they originally were called death insurance policies and accident and sickness policies, but their names were changed for euphemistic and marketing reasons.
A hazard is a condition that either increases the probability that a peril will occur or that tends to increase the loss when a peril has struck. The three basic types of hazards are designated as physical hazards, moral hazards, and morale hazards.
Physical hazards are physical conditions that fit within the definition of hazard. In the workplace, there can be numerous physical hazards—for example, the presence of flammable materials and the absence of fire extinguishing equipment, machines without appropriate safety devices, and faulty heating and air conditioning units.
Dishonest, unethical, and immoral people are moral hazards. Unfortunately, some employees qualify as moral hazards. The category includes those who steal from the employer, purposely damage employer property, file fraudulent medical claims, abuse sick leave and personal time off, or file false overtime and expense statements.
Morale hazards exist when people act with carelessness or indifference. Some individuals appear to be accident- or disaster-prone and, as such, are morale hazards. On the other hand, specific morale hazards include the failure to lock rooms, vaults, or areas from which valuable items are stolen; forgetting to notify the employer of faulty materials that ultimately cause personal injuries to a handler; or ignoring the fact that a number of employees all experience the same symptoms of physical discomfort, which ultimately can be traced to a job-related cause.
Types of Risk
Risk can be classified into many categories depending upon the use of the term. For the purposes of this chapter, a simple classification is used. Risk is divided into two types or classes, (1) pure risk and (2) speculative risk.
Pure risk is risk in which only two alternatives are possible: (1) either the risk will not happen (no financial loss) or (2) it will happen, and a financial loss takes place. Nothing positive can result from a pure risk. An example is illness. The best thing that can happen is that a person does not become ill. If a person does become ill, a negative result takes place. Many examples of pure risk are available. The risks of loss from fire, auto accidents, illness, unemployment, disability, theft of property, and earthquake all would be pure risks. Many of the risks covered by employee benefits fall into this classification. Pure risks for the most part can be insured.
Speculative risk inserts another possibility not existing in pure risk. The additional alternative is the possibility of a gain. Speculative risks then would have three potential outcomes: (1) a loss, (2) no loss, and (3) a gain. Examples of speculative risk would be the purchase of a share of common stock, acquiring a new business venture, or gambling. The emphasis of this chapter is on pure risk, rather than on speculative risk.
Pure Risk
Pure risk can be subclassified depending upon the type of financial loss. The three classifications of pure risk are:
1. Personal risk.
2. Property risk.
3. Legal liability risk.
The most important classification of pure risk from an employee benefit standpoint is personal risk. Personal risks are losses that have a direct impact on an individual's life or health. Many risks involving employee benefit plans fall into the category of personal risk. Death, illness, accidents, unemployment, and old age would all be considered to be personal losses. This type of risk can be measured with some degree of accuracy. It is difficult to be precise, but by estimating potential lost income from a particular risk and the medical and other costs associated with it, one can approximate the potential loss. With that information, one can estimate needed protection and seek insurance or whatever other risk-handling measure is appropriate.
Property risks are the uncertainty (possible loss) that decreases the value of one's real or personal property. Fire, flood, earthquake, wind, theft, and automobile collisions all are examples of types of property risks. The home, furniture, cars, and jewelry would be the types of property subject to possible loss. Legal liability risk is a loss resulting from negligent actions of a person that result in injury to another person. It stems from lawsuits by the injured party seeking damages from the negligent party. Common sources of legal liability would be negligent behavior associated with automobiles, one's home or business, the sale of products, or professional misconduct (malpractice). A serious difficulty connected with liability risk is that it has an unlimited potential loss. The dollar impact of this risk is a function of the seriousness of the negligence and the status of the parties involved. Malpractice awards against physicians or awards resulting from automobile accidents are examples in which potential losses can extend into the millions of dollars.
Employee benefit plans deal substantially with personal risks. The magnitude of life insurance, medical expense, disability income, retirement, and other personal risk-oriented benefit plans reflect this. However, property and liability risk coverage also can be found in a number of benefit plans. For example, homeowner's insurance, automobile insurance, group legal services, and financial planning services all are examples of property and liability risk coverages available through employee benefit plans.
Nevertheless, there is a considerably greater emphasis on personal risk coverages, and there are important factors that explain why benefit plans are less likely to include various property and liability coverages.
Methods of Handling Risk
There are several methods of handling risk. Although the main focus of this chapter is on the use of some type of insurance method to handle the risks associated with benefit plans, it should be recognized that other alternatives are available and are used. The primary risk-handling alternatives are:
1. Avoidance.
2. Control.
3. Retention.
4. Transfer.
5. Insurance.
Avoidance
Avoidance is a perfect device for handling risk. It means one does not acquire the risk to begin with and hence would not be subject to the risk. For example, if a person does not want the risk associated with driving automobiles, he or she won't drive a car. The problem with avoidance is that many times one cannot help but have the risk (the nondriver as a pedestrian or passenger still is exposed to the risk of other persons' driving), or one does not want to avoid it. For risks covered by employee benefits, it is almost impossible to use the avoidance technique. How does one avoid the risk of death or illness? The point is that one is unable to avoid some risks. Attention, then, must be focused on the other alternatives.
Control
Control is a mechanism by which one attempts either to prevent or reduce the probability of a loss taking place, or to reduce the severity of the loss after it has taken place. Many examples of control devices exist. Smoke detectors, fire-resistant building materials, seat belts, air bags, crash-resistant bumpers on autos, nonsmoking office buildings, physical examinations, and proper diets would be considered control devices.
Employee benefit plans can use control in conjunction with other risk-handling techniques, such as insurance. Any procedure used to reduce or prevent accidents, illnesses, or premature death would help in lowering the cost of most benefit plans. It is not unusual for employers to adopt accident-prevention programs, wellness programs, a smoke-free environment at work, and other programs with the intent of lowering workers' compensation and other employee benefit costs as well as improving employees' health and welfare.
Retention
Retention means that the risk is assumed and paid for by the person suffering the loss. Assumption or retention can be used with losses that are small in terms of their financial impact on a person or company. The cost of insurance or some other risk-handling device could be higher than paying for such a loss when it happens, and some losses can be handled more efficiently simply by paying for them as they occur. For example, assume you have an old automobile worth $600. Collision insurance with a typical deductible of $250 would give you only a $350 recovery upon a total loss. In other words, the cost of the insurance plus the deductible could be higher than the value of the loss. In such cases, it may be more economical to retain the risk than to insure it. One has to be careful with retention in that it should be used only with the types of loss that will not cause a financial disaster. Retaining or assuming risks with high severity potential can result in financial catastrophe. It should not be assumed that because a loss is unlikely to happen (low probability), it could or should be retained. The crucial factor is the financial result (severity), if it does take place. A fire that destroys one's home is unlikely, but it is devastating if it happens.
Retention can be a useful tool in handling employee benefit plans. An employer (insured) might decide to retain the first $1,000 of employee medical costs, by purchasing an insurance plan with a $1,000 deductible. Another use of retention can be found in the administration of benefit plans. Employers can take over many of the administrative duties of the insurance company. Payroll deduction, claims administration, answering questions from plan members, and filing of forms sometimes can be done more efficiently by the insured than the insurance company, and by carrying out these functions itself, an employer may be able to lower its direct dollar outlay. However, this form of retention should be examined carefully before being adopted, because the administrative burden and other negative factors may outweigh any potential savings.
Transfer
Transfer is a concept in which one switches or shifts the financial burden of risk to another party. Two forms of transfer usually are recognized. For example, a landlord may require new tenants to pay extra money up front as a security deposit for potential damage to the premises. This would be a form of transfer. The landlord would be transferring his or her possible loss to the tenant. Another example involves travel agents. A client may want to travel to the Middle East during a time of potential military conflict. The travel agent suggests avoiding the area. The client insists upon taking the trip, but the travel agent has the client sign a form waiving legal claims against the travel agent for dissatisfaction with a trip that the travel agent has not recommended. The hope is that, if a lawsuit develops, the travel agent can assert that the traveler took the responsibility for the burden of any loss upon himself or herself.
Employee benefit plans use transfer extensively, but it usually is in the form of insurance contracts. Noninsurance transfers typically do not serve as risk-handling mechanisms in benefit plans.
Insurance
Insurance is a common method of financing employee benefits. The definition of insurance varies depending upon whether one is looking at insurance from an economic, legal, social, or mathematical viewpoint. However, for purposes of this chapter, the following definition of insurance will be used.
Insurance is the pooling of fortuitous losses by transfer of such risks to insurers who agree to indemnify insureds for such losses or to render services connected with the risk.
From the standpoint of an employee benefit plan, insurance would be a mechanism in which the insured (employer/employee) would pay money (premiums) into a fund (insurance company). Upon the occurrence of a loss, reimbursement would be provided to the person suffering the loss. Thus, the risk has been reduced or eliminated for the insured, and all the individuals who paid into the fund share the resulting loss.
Insurance is but one method by which an employee benefit plan may be financed. Large benefit plans may rely on insurance, self-funding, and various combinations of the two. However, many small- to medium-size firms rely almost exclusively on the insurance mechanism.
Before continuing with the discussion of insurance, it is important to clarify the difference between insurance and gambling. Since both insurance and gambling have a relationship to risk, they sometimes are viewed erroneously as essentially the same. However, there are several important features of insurance that distinguish it from gambling. First, insurance is a mechanism for handling an existing risk; whereas gambling creates a risk where one did not previously exist. Second, the risk created by gambling is a speculative risk; whereas insurance deals with pure risks. Third, gambling involves a gain for one party, the winner, at the expense of another, the loser; whereas insurance is based on a mutual sharing of any losses that occur. Fourth, the loser in a gambling transaction remains in that negative situation; whereas an insured who suffers a loss is financially restored in whole or in part to his or her original situation. Obviously, the insurance-gambling discussion is more appropriate to individual, rather than to group insurance, but the comparison also has some applicability to the group mechanism.
Additionally, the use of insurance to make the victims of losses whole reflects the principle of indemnification on which insurance is structured. An insured is indemnified if a covered loss occurs. That is, he or she is placed somewhat in the same situation that existed prior to the loss (e.g., by reimbursement for damaged property or medical bills, disability income, and the like).
Summary of Risk-Handling Alternatives
It is possible to use a number of alternatives in the design of employee benefit plans. One or more of the alternatives in some combination is common. The one alternative that is mutually exclusive of the others is avoidance. If you avoid the risk, you are not subjected to potential losses, so that no need exists for insurance, loss control, or any other risk-handling technique. The remaining alternatives, however, could be used in combination.
Assume a typical medical benefit plan for a firm's employees. The firm might purchase a medical insurance plan with a deductible of $1,000 per year per covered member. The plan is insured, and so transfer has been used. In addition, someone must pay the $1,000 deductible, so there is retention or assumption of part of the risk. Further, assume that the firm is interested in keeping the cost of medical benefits down. It may initiate a number of control devices, such as a smoke-free work environment and an accident-prevention program to aid the effort. Thus, a number of the risk-handling alternatives are used together.
Another example of benefit plan risk-handling alternatives involves long-term care. Long-term care insurance has had a slow growth in the private sector. Recently, there has been an increase in the popularity of this insurance but the fact remains that most families remain uninsured for long-term care. The high cost of this insurance, restrictive underwriting, tax issues, and the lack of the public understanding of the problem have all contributed to this fact. The cost of long-term care insurance directly increases with age, the amount of the daily benefit, and the shorter the length of the elimination period. Often families put off the decision on this type of protection until later in life when the cost has increased considerably.
Although the need for long-term care cannot be completely avoided, serious thought must be given how to handle this risk. Likely techniques could be insurance (transfer), proper health care and living conditions (control) and finding a way to pay for the loss out of savings or income (retention). Retention may be the only available risk handling technique, but employees and families must seriously consider how to prevent a catastrophic loss to the family. Accumulated liquid assets may be adequate to pay this loss but this is a sizable sum. Insurance, Medicaid planning, planning with potential caregivers, and increased savings amounts are few of the areas that one needs to analyze to determine what is best for the family in the solution to the problem. Employers are taking an increasing role in helping employees understand and cope with the problem. Insurance and long-term care planning are examples of help provided by the employer.
What factors should be considered in deciding upon the "best" method of handling the risk of a particular benefit plan? In general, consider the most economical from a financial standpoint, but with proper consideration given to employee welfare. What is being suggested is that there is nothing wrong with opting for the lowest-cost alternative as long as proper consideration is given to the nonfinancial aspects of the employees' welfare. Failing to put a guard on a machine to prevent injury is generally unacceptable, even if it might cost less to let the accident take place. Firms must consider employee welfare and mandatory requirements set forth by the state and federal government in evaluating the alternatives for handling risk.
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