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CHAPTER

-2

f;

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DEFINING

THE INSURANCE

EVENT.

:,:

~i
f,

IDEALLY

;f~

The fol.lowing
exposures
are ideal for insurance
g e' ( r::./ ,n~
~~\)ioQ..v)
.
covera
, r
.
.A
large group of similar items exposed
to the same
peril(s).( \~
tfb WO~)
.'

,if;'
,
:[ ,
* j
~

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"

INSURABLE

8 Accidental

LOSS ~~O~ESV;-~)

losses.

11

.Definite

]~
-hardship.
1"
1~;
8 Extremely
~;"

losses

capable

of causing

economic

10~_.QrQ.b.a!bility of a catastrophic

the insurance

loss

to

pool.l~\"\D--\Y"'-"',~~L\.-)-~'~-

11,

'};,,'

~i

Large

numbers;

l\~ ~

~~1'e.
tY'-~ e..-~j)

1,
r
,~'
,
-~
i!

It means that number

of exposures . large enough
to
allow for predictive
accuracy.
The size of the insUrance
pool is large enough
to estimate
results
with sufficient
ac~~~~to_lcula~e.a
~ound insur~n~e
pr~mium.lf::,~i~x

'I' :
~:!

The exposure
units need to be similar
so that the
insurer
can calculate
a fair premium.
The fire damage

't..~ 'y\\" ~~)

done to brick homes will ordinarily

be less than that
suffered
by wooden
homes.
It would
be therefore
not
fair to combine
them in the same insurance
pool and
charge each insured
the same premium
rate based on
the combined
losses
<;>fthe pool.

Losses

must be accidental

and beyond

the insured's

control
Non accidental
or exp~ted
reductions
of economic
value, such as w~\gnt:c!lear7
are not insurable
events.
'A ' L

-L-

l~. f ~ )

nil.

...".+

~ W"::>~...f:- ~ \) rt">-")..(A

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cfm'-

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~'[

t, ~

'~~

mJ-- ittA/1.Je.,t~

&Il,c.,-ne~ -t:.Jct
f-rroe:i~l!.C';

II~

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-r

i
,

IIi I)ractice,
intentiol1c:l!: losses
are 3-fraud
f
--against public
policy.
Thus if discovered,

c
~

company
vvillnot
pay for an insured's
intentionally
caused loses. rVioreover, m~ntionallosses
may cause.
c,'imina!
charges
such as ~
or .theft to b.e brought
against the person
responsible
for such crimes.

.,

Accidental

lasses;

N~~-fraudule~t

losses

and are
an insurance

~r

f-

arising

from

an insured's

-;?
;1

negligence
are insurable.
This is the case
example,
an insured's
had driving causes

when, for
an accident.

good example
of the application
of the principle
of
accidental
losses occurs
with life insurance,
for which
suicide
within
is considered

a year or two
non accidental.

being purchased
do not pay such

.:
I

losses.
If a suicide
occurs
beyond that period,
the lo~s
is considered
accidental,
the result of mental illness.

i
I

..eu..(\D

of a policy
Insurers

"",,'v

Losses must be d_eflnJte, measurable,

.~everitv to cause economic
hardship

\/r/'lu

and of sufflc~nt
V

r
1

Insurable
events
must be definite
and verifiable.
Otherwise
there would be many disagreements
between
insurer
and insured
to determine
whether
a loss has
occurred.
Thus individual
can be insured
against the
loss

of house

as the

result

of a fir but cannot

.~
lI

be insured

I
I

against
insured

its loss
against

as the result of a fire

its loss as the result

but cannot
be
of its being

!,
!

haunted.
The damage
caused
by insurable
events
must be
measurable
in economic
terms. The loss of loved pet
can cause a family much grief, but such discomfort
cannot be measured
economically.
Thus losses
of pets
are excluded
from standard
home owners'
insurance

:,
I:
r
i
i
I
!

contract.

when

As a rule,

losses

l~y~c}J!J

insurance

are large

should

be purchased

only

and uncertainLTh~~~rge

e)

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51
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,
: .~

..~

,.:to:,

1 ','

wi'.

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available on aJdvanced funding. Captive insurance

conlpanies
appeal to,some organizatrons
because

-/

i .i
I
.I
II .I

organizations
see one or mo~e of the following
advanta g es'~'(~i.

..Improved
f
t
c

the

potential

Loss Preventio~ Incentives. Th~~ ~

offers a chance to reap ?Irectly t~e beneflt~ of

r I
~

successful loss control.

.Improved
Claims settlements.
This advantageincludes the ability to cover claims or exclude

claims with more flex.ibility than a commercial

.'

Insurer.
.Improved
profitaoility.
This includes the
investment potential from investing cash flow or
avoiding premium taxes.
.Economies
of scale. A captive insurance
~
" .--"
'
..
operatIon also allows Gomp~nles wIth many
subsidiaries
to combine the insura'nce needs of
these subsidiaries
under one insurance
~
program. "In areas such as the automobile""

-'

'

.liability

expo.sure,. a self insur~nce fa,cility

combined with retnsurance
might allow
considerable
saving compared to the cost of
each subsidiary com'pany purchasing
its own

I
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.V..' ~,.,
~ I-,
,.1.11""'"

coverage,

,II}
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W
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...'

~-"l~t.~)

DeductIble/RetentIon;
Some companies
have
taken the middle:':6f-the-road
posrtion between
c%mmercial" insurance and forming a captrve iRsurer.
~
do this by c,areful use of the deductible
provision

,
!

in their insurance
or the self-insured
that the insurer
~ISK

policies. The dedu"ctible provision,~

retention, determines
the amount
must pay.

I rarl~rt::r

,
;

70

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--!-"~:::';;=...=_.

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Insurance

is the best risk transfer

means the original

pali% exposed

mechanism.

~
.I

.'. ".~

It

to a 10'5s is able to

obtain a substitute
paliy to bear. the risk, Risk transfer
i~ a fea~ure of all iris~rance transaGtion~
because the
\ uncertainty
of who wIll pay for the loss IS transferred.'
f~om the individtJal to the insurance pool. .,
~,DJ~

~~~O~,J
~'(\"'-

Insurance-Ltif).v,-~~

;/

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From the risk manager's viewpoint,

insurance
represents a contractual
transfer of risk. From,.,
society~s viewpoint,
insurance is more than mere~risk

/'

transfer;

it is risk reduction

; f
;

,.q
1

be-cause the po.olingof

numerous risks allows better loss predictability.

After deciding to insure a paliicular
loss

""

,-

l~~

exposure, he risk manager sti,ll faces many decisi,ons.

These include choosing an insura.nce company'.,
.
choos\ng an \nsurance agent or broker, and choosing
an \nsurance

po\\cy. ,Atter the \nsur~nce

coverage

has

been arranged, the'r\skmanager's

work sti\\ is not
complete. He must make sur~ the company does not
violate any {he terms of insurance ag~eement.
If the
contract is conditidnal
on the' company's
employing a
: security guard or maintaining
a ,fire sprinkler system,
the risk manager must be sure that these conditions
are met so that the contract is not breached.
~'.o

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Catastronh1'c
~'-"
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c~,

Loss exposures
vvith catastrophic
potential
are not.
insurable
events.
Catastrophic
loss exposure
is ar
potential
loss that is unpredictable
-and capable
of

::;
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cr~
}"
~:
c~
!1,;

lass'es
,~~~~'-'

producing
an extraordinarily
large amount of damage
relative to the assets held in the insurance
pool.
Catastrophic
losses are the subject of the state, Insurer
normally
do not provide
insurance
for catastrop.~ic
losses due to the following
reasons;
.The
loss potential
is catastrophic.
.The
loss potential
is geographically
restricted
mostly to flood plains and river valleys.
.The
government
at the federal level has be

I
\

ability to pass zoning ordinances

restricting
use of flood prone areas.
.Those
people
most exposed
or most likely to
have claims
would be most likely to purchase
this coverage.

When only the people

most exposed

to a particular

want coveraqe, this loss is not an insurable

loss

event

An insurance
system
operates
successfully
when
many people or business
firms faced with similar
exposures
transfer
their potential
losses to a pool,
paying a relatively
small premium
for the right to collect
losses payments
from the pool. Using the law of large
numbers,
the pool is able to predict losses
accurately
and charge a premium
appropriate
to the risk. The
syst~~
succeeds
if th~ premium
is small relative
to the
potential loss. Because
they are risk averse,
most
people are willing
to pay a relatively
small certain
price
to avoid a relatively
large, uncertain
loss. People have a;
price, however,
beyond
which they Vlfill not pay toI
transfer a risk.
J

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TERROR[S~/[

II'.JSURAf\!CE

,--,~.'_.

September

11, 2001

t ~ ~

'

\M'~'~

,~,,-t~

terrorist.

attacks

OQ~

.J \.

..\.

(~V

Y1~~~.)

;r

-'t- ' ~

\\..;)

with

ranging

from

INSURED

f~TRE

current

estimates

{'),

~ a,.-- ~ -{;.,~

-\oar

V\~

on the World.

Trade Centre in New York and the [:'entagon, in

Washington
produced
the most insured
damage
history,

in

of the insurance

\\

claims

$40 to $60 billion.

LOSS ESTIMATES

FROM THE SEPTEMBER

~NQ e~!'JT1~

,-,wc"'~~eo~~
1~

(\)~~.e.,~'s~-?I.\o~;l-}\>co.I)'.)-S'"""--~'

~,~

_","1

~~

'1.~~~

C.-'6M~~~
i...,) ~~
(). \~\).\~

~;

.Aviation
liability
claims
arose from deaths,
Injuries
and property
damage
suffered
because
of cla'ime;d
negligence
of airlines,
airports,
security
services
and others
in not providing
adequate
security
-$4$10 billions.
.Aviation
b.YlL!claims
aircraft

involved

.Life
insuranc;e
people killed'in
both

group

arose

from

in the attacks
claims
arose
the attacks.

and

Individually

the loss
-$500

to the

million.

from about 3,000

Insurers
paid claims
purchased

policies

billions.
8 Property
insurance
claims
arose from the
destruction
of the World Trade Centre towers,
buildings,
and other property
including

for
-$3

other
!

automobiles
-$9-$12
billion.
.Business
interruption
claims arose from the lost
profits
and extra and continuing
expenses
of
businesses
that were forced to close, relocate,
or
were unable to operate
in a normal manner
after the
attacks

%10-$12

billion.
I

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).1

1'"

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c"
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-['Jevv

(~~-l(C;al-lce!!:~i
CIa_rillS ,arose,f['om businesses
in
York City and elsewhere that did not proceed
with sch'eduled events because of the attacks -$1

-billion.

The September 11 attacks also produced billions of

dollars in uninsured losses, including the cleanup costs
--in New York, the damage to the Pentagon, and the
uninsured
business interruption
losses suffered by the
tourism industry throughout
the world. Moreover, he

cost of increased security to prevent or mitigate'the

cost
of future attacks and the cost reflected in the economy
in general and the stock market in particular
are real and'
must be added into the final estimate to the total
damage caused by this only one terrorists
attack. /i1

Lt.)~ ~
DEFINING TERRORISM
Terrorism
means activities
against persons,
organizations
or property of any nature that involve
following
or preparation
of the following;
.Use
of threat of force or violence; or
.ommlsslon
C P1".J-",Ji:..
or t h reato f a d angerous act; or

the

.Commission
or disrupts
information

or threat of an act that interferes with

an electronic,
communication,
or mechanical
system.
l.\~Pt
C.(rV.1~)

GAMBLING LOSSES ARE NOT INSURABLE

EVENTS
GEjJ1blitlg and in~urance are 1?.PQj~. Gambling
creates risk (uncertainty)
where none previously
existed. Insurance reduces risk through pooling and the
operation of the law of large numbers. Insurance
against
gambling losses is not economically
possible.
Insurance against gambling losses is not economically
possible.
If gambling events were insurable,
the gambler
would be put in the enviable position of being unable to
~

54
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--"-'~~_c-

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r;
t;

[ose. t_avv prohibits

us:{ng inSllt.~arlce contracts for
garnbling by insuring property one does not OVVI1,or
insuring lives in which one has no legal interest.

"\:'

.
BJ~
CLASSIFICATION
A,~D 1~.S.~B~~E
I\~~!6~'~~
if ;1'11wu-o1l~
a.,'vi'vj M pie..miuw.~ ~I'bl..Iftro.-.
,'L I'~ ~~
SUBSIDIZA TION

'

9Il..-~
-

~~~

Each insured's
mathematically}ff
share of losses
and expenses is based on the expected probability
of
loss for the risk class in which the exposure is 'placed.
Subsidization
occurs if each insured dos not pay the
mathematically
fair price for insurance.
If the insured is
paying more than the mathematically
fair price, the
insured provides the subsidy If the insured is paying

less than the mathematically

fair price, the insured

receives a subsidy.
It means every insured in a pool must contribute
a
premium matching with the risk he, is carrying at the
time of taking

the insurance

cover.

~VERSE SELECT/Dlll rsjLfY'cdtj ft4 ~ ~-""""' I'~ ~

Adverse

selection

me-ans accepting

.!"'Ut:Ac
~ ,'\"1
~

a risk by the

insurer which is above average risk, at a normal rate of

premium. For example, adverse selection
occurs when
people who know their health is deteriorating
try to
purchase health insurance to cover the cost of a needed
operation. Adverse selection raises serious ethical and
moral questions,
but it is an ever-present
fact in the
insurance

market.

Applicants
for insurance
with a greater than average
chance of loss would certainly apply for insurance.
If
these above average risk applicants
succeed in
purchasing
insurance
at average rates, the insurer is a
victim of adverse selection.
J
/',0/'

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55

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PRINCIPLES

OF RISK

CLASSfFICA

TIOr\!

In GeneRal.Ra.1'e
Cla.5SIP1C8.1IOn
ra,CliORS
,an Be evaluated
following four points;
.(SA-t

'

Se aratJon and class homo

':J
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7
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1
;}
;{;;
, !

on the
.

e eit ..

If the insurer has constructed

its risk classes
carefully, each class will have a significantly
different
expected loss (separation).
Moreover, each member of a
given class will have approximately
the same chance of
loss (class homogeneity).
This rule prevents combining
males ages 20 and 40 in the same life insurance
pool
and causes a mathematically
fair insurance exchange.

.J
i :'

::;; Reliabilitv:
': :
;'.
,

If insurers decide to use a particular factor for

classifying
insureds,
information
about the factor
;

.)1 ,should be easily obtained and not subject to

'; ,Jilmanipulation
by the insured. The variables of age and
i
sex would meet this standard, but asking an applicant
...,;;1
how many miles are driven each year or whether drugs
,
["
or alcohol are used would not do as well because
"~
insureds can provide false information.
Incentive

value,.

Factors used for risk classification

should reward
good insureds (those with below average loss potential)
with better insurance rates.

Social afceptabilitv;

There should be no discrimination

on the part of
insu:er in ~cce~n~the
risk such as individual's
genes,
credit scoring I r~ce'i!: etc.
.

:i
,

BRANCHES

OF

INSURANCE

;:
!
:

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56

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';~' QQ.Y.sB~.ME.Jil
., Social

~-~J

security

.Unemployment

Life

l'-Jon life

Life

Fire

Annuity

Marine

Medical

Exp.

Bondiilg

~~saJjJY.
Automobile

Liability
Crime

WorkersCompo
generally
covers
sta1\onary
property
Fire Itinsurance;
cJ..#
r~&.e.s1ate. However,
land .is not covered.
j
simple
\; .covers

also

called

'

Another

way of putting
it is ~hat ~ire insurance
generally
buildings
and their ~:@reiliS~/tin
addition
to the

j
~:

peril of fire, more broadly

policies
provide
payment

.:~
)';.!

perils as windstorm,
riot, and vangj;!}jm.
Another
type
of coverage
associated
with property
insurance
is

f
Ii:
"

business
provides

~~

damage

'J

income
payment
done

based property
insurance
for damage
caused
by such

(interruption)
for indirect

by fires

coverage,
which
losses associated

and other

covered

with

perils.

~!.
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'I

Marine insurance
It generally
covers

:,;~l

insurance
covers
marine insurance

'~; f
it

mobile

property.

Ocean

ships and their cargoes.

covers
property
moving

marine

Inland
on planes,

;~t
(
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l.ra[l1s~ ar-ld iruc['cs. T[~11s$-categor)ris often called

.transpoliatron
insurance.
Oe..-!lf.
~as~alt)'
l~nYr?m:;.e

It describes
several different fiel..ds of insurance
-including
autom~bile
insurance,
liability insurance,
crime insurance, workers'
compensation,
and accident
and health insurance
i:
~
Bonding
1

It is a special type of protection in which one party

(the surety) guarantees
the performance
(surety bond)
or the honesty (fidelity bond) of a second party to a
third party. If the second party's poor performance
or
dishonesty
result~in
a loss to .the third pa,rty, the
.~-t{l
surety must pay. ;~ rl:Ji,"~
1'1J'1)~ IOJIolf~-t
~r.:eIf)~""~""'L (JY"'r-~
Life insurance
It describes
insurance
based on human life
~~..,..,., I~II'V\.PI~
contingencies.
If the covered peril is death, the
J..- Wh~L lik
contract is c~IJJ;R I~!e in~ur~~~~~. If the peril.is survival,
1~~1t (.,l.;o

I
i

the contract IS cal'ecr~

~rilfiMY. The annuity
3- ~'VV\1f;jj 1I~
guarantees that the insured will not have to survive
~
'1 W't if
without money. If the covered peril is sickness, the
coverage is called medical expense insurance.
If the
covered peril is disability,
the coverage is called
disability income insurance.
Credit

insurance

Credit insurance

coverage

is an example

for a speculative

insurance

arrangement,
the insurance
company provides
payment to its insured (the lender) if the insured's
credit losses exceed a specified amount. In other
words, the insurer pays the lender if the lender losses
money because its debtors fail to repay their debts.

I
I

of insurance

risk. In a credit

I
S8

_.~r~;

~-C--""".~"'"..."-~""'-""'"'C':","".""""""',,"':="'1"""~,"".~'!""'='.~"""':1:Z!"C"':'(.;;~~l:.'.:t~,,!,[";;~

)f'r

.,

.(
I

~~JLITY if\\~URAt~

l.~I~
~~ insurance
~
p.".,.".
Legal
liability

It provides protection
against the financial impact
of lavi/suits.
;~~~'f1"L~if.e.~~
America, Europe especially UK is a li!lgiQ!:!
,~~,
society.

When we have disagreements

~~8(

that are not

quick~y resolved t? our s~tisfaction'\Jwe

s~p',:.~~~
our friends, enemies, social clubs) Q~~Qy~!Irnr~t
physicians,
insurers,
church'es, government,
teachers,
school boards, butchers, bakers) candlestick
makers,
and our parents. Using the courts to resolve our
differences
is better than the alternative.
But it is
costly. Direct costs include attorney fees and court.

!
i

costs. Indirect costs

services) elimination
vaccines and closed

I
I
I

environment

where

and personal

include higher costs of goods

of products
and services(like
beaches), and a hostile
fear of I~w suits

inhibits

and

business

activity.

Legal background:
The peril of legal liability arises out
of the general rule of (English common)
law that people
are responsible
for any loss (injury) they cause another
to suffer. The law creates here categories
for
describing
situations
in which one person injures
"-

another;
.Breaches

of contracts

(c,'v: t)

.Criminal
acts
.Torts
or civil wrongs.
Breaches of contract involve

a failure,

;I

without

excuse, to perform contractual

duties.
Criminal acts are those acts which in general
;

wrongs

against

a legal
are

society.

,i
i

t\

59

"

i',

II

,;.

.~I

,-_. ~"."'

""""";::,,.,-"',",':'
0,,\

"f~

.~
.f
.'.:.

",,\
,c"
'"

,;r, .,Torts.
.\~
iirc
'Ii

or" ci'vil v,trol-tgs: involve

'

.,~
t

'

Ut-lrea::sonable conduct
'

to\f\!ard another person. Touching another person

without R~~.e..s.s._d.ri~ng
permission
may be
both a civil
and could
criminalbe
wrong.
is another
act that
both a civil and a criminal

wrong.

;--NEGLIGENCE
Negligence
involves doing something a
reasonable person would not do, or not doing.

something
a responsible
results directly in some

.
'

person would do, which

injury to another person. A

reasonable
person is one who have normal
possession
of all faculties and senses; ~ho thinks,
speaks and acts based on reason)and
who is honest
and moderate in all activities.
Violating the reasonable
person standard can result in a court imposing legal
liability for a person's direct acts or omissions
of A C-D.l\.R..
actions.
U) T",,- ~~~~~
&"-.-{..~0\ ~
v~
i

'

Vicarious

liability;

th~~~gli9~~t-~~ts

u')
Ii\\)~~c. ~ ~~~~~~~e~~~~
~ \3(~
~ 1lJ.bh~

Courts

can also impose

of another

parties;

.I-~~if~~~
I ~}~ sIl.-~f\
-U -p

liability

Vicarious

for ~~

liability

means a person is liable bec~use of an~ther person's

acts. For example. ElllE\Qyer ~~J3,.,sponslble for the
acts of his employee;

~~~!~.1~~~!Qn.lQI~

?~
~Jj~4
~

for the

acts of his servants.

Joint and several liabilities;
If a party is one among
~~~~I":~~p~~'S"ible
for a-loss, even it its contribution
was the slightest of all, it is fully responsible
for
making restitution
to the injured party if the other
defendants
are financially
unable to do so.
~~g~ence.~~~~~~;
Wh~n a caseL goes to co~rt, ?ften
the purpose IS to determine the~ats.
After revIewIng
the evidence, judges or juries determine the facts.

60

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~ ~-"-

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;, Gi)

v~ ~

(:4~~~~:;l)

"r .

;-

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Ollce a judge C)I jur}! d'etermines

the facts~ the judge
applies
the
apprQpriate
legal
retl1ed~uU-~'t<-dl
~
r
!
~-~ ':
:O~~
\ " M4 '"""'I
~
-~

VOl

.r

I.

Pfalntlff/Defendant;

There

are two

parties

~ b

to a

be plaintiffs

or defendants

.'negligence
lawsuit.
The plaintiff~ is ~he party, claiming
, injury. The defendant
is the party from whom recovery
c) is sought.
In addition
to human beings,
business
firms, government
units, and other organizations
may

,f(
(,t

/\
l~ ~

t/\.f'tl.t?:

C'(

in lawsuits.
..

Establishing
negligence
ana' damages;
To establish
case of negligence,
the law requires
the plaintiff
to
prove all of the following;
.The

defendant

had a legal

duty

to protect

a
\

the

plaintiff.

.The'defendant
.The

failed

plaintiff

to perform

suffered

defendant's

failure

an injury
to perform

that

duty.

as a result
that

:
of the

duty.

Judgment;
if each of the three elements
of a negligent
act is established
to the satisfaction
of the judge and
jury, the plaintiff
usually
a specific
official
parties

i~' entitled
to a favorable
judgment,
sum of money.
A judgment
is the

decision
of the
to a sUit.l~'~~~

COMPENSATORY
~

court

I
i,

as to the rights of the

~) ~Its f6~)
",It (,. ~~
~~ ~

--0/1
IJ.o\IU'
~'-{...

DAMAGES

I'
f
Ii

-I,

Punitive
damages;
not as compensation
means
offensive

these are awards

made to plaintiffs
for injuries
suffered
but as a

of punishing

defendants

:.

for outrageously

acts.

L...W/rb~"

r-'-

R~J1!.:?E.-1oq.uitur;
It means
cases, the plaintiff's
injury

things
speak
is the obvious

itself. In loo.meresult of the I

61

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e.- (r"f"'" ~ CJ/r~a~

j~t1:q

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~
!~

defends.ot's activlty. [[1 such cases, the court ma)'

.apply
the doctrinej vvhitZh is a legal doct,'ine of
evidence allowing the jury to infer negligence on the
pari of the defendant.

DEFENSES IN A NEGLIGENCE SUIT

Contributory negligence;
At common law if I can be
shown the plaintiff's own negligence contributed to or
led to the injury sustained, the court will not allow
recovery of damages from the defendant under the
contributory negligence rule..'.;~ llU,d!IVtt'J ~
~~
~~~
Comparative negligence; The comparative negligence
doctrine allows plaintiffs some recovery despite
contributing to their own injuries. Damages are
reduced to the extent plaintiff contributed to the injury
or damage to the property,..Normally 25% damages are
reduced at the maximum.
Assumption of the risk; It means the plaintiff
knowingly assumed the ris~ of injury. If the defendant
establishes assumption of the risk, the plaintiff will not
be awarded a judgment. For example, if the plaintiff
challenged the defendant to a wrestling match, the
plaintiff may not collect damages when his arm is
broken during the contest.( '(~jb'" ~~~I'!:o -e-t.-.4~ w.~
***************

Cva-t'

(jv,:) 1'~t[,l2.~
't\;,L

~~

6~\J-e..~--e.~)Oti ~4

~~bc-tltl..b~

62

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:'

CHAPTER-3

RISK MANAGEMENT
..

THE NATURE

OF RISK

The conceQtof
rlk;
..
Risk is present everywhere.
We frequently
hear news
on television or radio such as; some major fire,' explosions,
earthquakes,
collision
on roads
workman
falling to his death from a building.

or a

There may be certain news appearif'"!g in the

newspapers
e.g'.' fires, robberies,
airplanes
crashes,

.i
i
[;
;

.56

:
,

,
,

;
etc;

All of us might be involved with one of these events

such as car accident, our house may be robbed ,or
damaged by fire or Wtmay suffer some disease preventing
I,

t
l'
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r!!
: :
;

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'

.~'

I'

j.

'~ :

US
e.g," going
factory for may
work, be Businesses
destroyed

,
.:

i'

computer

record

employees
Behind

orevery
third

are

involved

closely

'.'

sophisticated

.\

is used,
hardshIp

Risk

damaged

very

mechanism

properly
caused.

is at the

few

lies

know

behind

may
result
into.
That
mechanIsm

very

centre

be in risk'

caused

to the

or injury

partyanxiety
on the and
premises,
risk
grief
but

involved
could

exist
that

for

those

ther'e

oeach

ri,sk

and

'l'

':.'

,'."
' ' '~
-

who

if thatl

alle~iat~
the,financialI
IS called
Insurance.,

of insurance.
.

Qg!lnition

of.1l.J5.

.Risk

is the

chance

.Risk
.Risk

is the possibility
is a combination

.Risk

is the

economic

of loss,
of unfortunate
of hazards,

~ncertainty

as

to the

ocqurrence;
~~
~~;
occurrence

is unp!edictability,

may
.Risk

differ
'from
predicted
results,
is the objective
doubt
concerning

the

situation.

'

suited

definition

best

those

'( i~~

of

situations

so far

which

will

world

actions

such

life,

as

of losses'.
likelihood

~.!!f~..d~ill!Y.~DS:!~g~ill.~~
We. are living
in he
throughout

tendency

that

actual

the

result

outcome

in
.

concerned
is luncertainty
avoids
situations
where,no
also

'

.Ris'k

The

loss,

a given

insurance

topic

This
definition
of loss
exists

definitely

happen.

of uncertainty

is
.C:tnd

~~

in most

~d,

of our

as;

"

.We

do

.If

we

not

will

know

if we

succeed

will.

in the

pass
job

an examination,

interview

given

or

able

to

get promotion,
Similarl

there

is a lot

of uncertaint

in business

e.

57

..

is a

;
I

~!

stolen,

by
can fire,
also stock
be

.'I-

in ~

t ' ' .';10';";

",

..
.'

.' "

.If

we Invest in new machinery

expectation?"

e If we launch

will the output be up to

J'
,.

a new product wiU it se"ll as expected?

.If
we build a new factory will it burn down?
0 Will thieves steal our finished product from. the
warehouse?
"

However
in certain cases we have certaint
such as'
0 We know that if we reduce the number of machines

'

used, our fuel bill will~ome down.

.If we employ four new people., pay roll will increase.

FORMS OF RISK;
As far as insur9nce subject is concerned we are
concerned with those risks which involve some loss that is
capable of financial measurement.
There are two types of
risk;

"

Pure and Speculative

risk~

:
;
i

..

:
.(:
~j1

Pure risk
In certain situations a loss or a bre"ak even position
may materialize.
Driving a motor car is an example. Every
time yo~ take your car on the road you run a risk and
there is the urlcertainty of loss, you may damage your car
or injure another person or damage his property. In case

:
!
i

t: ,;

you get home free of incident

say you have

or a profit.

':

brgJs.e.n~vEn.

Speculative

then we could

.1:

You may risk

experience

a loss, breakeven

You may purchase share at 2~ each and after a year

there may be three positions. Its worth 'may be.20p"and
you have suffered

a loss, its price remains

25p, this is

58

I
:

";

3~~'~

" "',"

break even point or its price may increase to 30p and in

this case you will gain profit by the sale. .'
In business environment
speculative
risks are very
common
such as exporting to a' new market or I,aunching
a new product.

~~-=:::::::::-:..;.!Ii,~j~~~-f.

.~

.' ';
,'.

-.

.E~.!l!damentaland partic~larr il5:l

E~ndamenta/.
r'~ risks
Fundamental

arise out of the nature

society we. have or from some physical

,,;

."~~

of the

occurrence

beyond the control of man, e.g. ~

inill..e.timn,changin~
9.~EJgfJ)S, natural causes such as typhoons, tornadoes ,etc.

.i
,

E-micular

c
;!

Particular risks are those risk which are based on

individual events and its Impa'ct is felt locally e.g. theft-of
property, accident'damage
etc.

g.b~ge

"

risk$~

!n classific~~

With the pace of changes'

in the society~ classification

or risk is also changing. In the past unemployme"nt was,

consider'ed due to the fault of. employee, ~ow it is,
considered
a risk arising due to the malfunctioning
of the
economic system', Another example is of mbtor acGident.
Instead of considering
only fault of a driver in the past, it
may' be due to other'combined
,

factors

unconcerned'with

the driver.

~vsical

haza~

I
~

S9

,
;:'

('r"

, ,.
."

.:.

'. .

It relates to the EbYlg.~ or t.9.D.9j.Q~aspects

.~:

, -which

are likely to influence

the occurrence

of the risk

'

(frequency)

and or severity of loss.

.
Where the likelihood
and severity
of loss as
compared to an average risk is high, it is t~rmed as poor
or unfavorable
physical hazard. Conversely,
if aspects.
which are likely to reduce both these factor these are
called good physical
features. Examples are;
,

FIRE

Q.Q.Qdphysical
Property

features_~

contains

brick or concrete

metal fire doors automatic

;~Q

v1~imber

phvsicalfeature~
walls,

packaging

THEFT

storage

sprinkler

of dangerous

fir~1Q.Q..::!':i.gllis and
and a'larm sy~tem.

chemicals,

oils,

materials.

~_od phvsicalfeature~

c.'(~ong

building

construction,

security

locks and bolts and

"{'):J\~~ Intruder alarm system.

.-

~:

,j:;
i I
l'

:!

pbvic~1 f~atur~~

Light weight constructed

normal window catches,

~d

;f ;

Wearing

;: ,l

walls or roof such as timber or

possession
of jewelry, wines etc.

I
'

MOTOR'ACCIDENT

':::
'" ,

physical

'

feature~

of seats belt, matured

density populated

drivers,

.usage in non-

areas.

" .,
;J;

~_d phvsica~ f~atur~

I
I

hI!.'

I
'

---1

1..,

", ,

.:

1.

Use of vehicle in areas of high traffic density. Taxi remains

most of the period on road. Cars, which, are costly to
repair i.e. Rolls Royce.

I.

i~

:'

..';",

,-

..

LIABILITY

.')

,
,

,
!,

;'

."

Good

physical

features;

l)se of protective
Bad physical

clothing,

~~
goggles

and masks.L.Po \~'bV-"'\~

features;

The use of chemicals

industrial

.~
oils, creation

of(d~s!

processes.

(~I"(~

~nd_v~~~)n

A~'\:o..-~.

..

MARINE
Good physical
features;
Employment
of trained and competent

staff.
I

Bad ph~sical
f~~tures;
..'
Use of poor equipment or maintained
cargo on deckl~
~~~'4'),.

~J
vessels,
-

storage

of

PE"RSONALHEALTH
'1

Good

VVorking in cQD.Q-.enLalatmosphere.
blood pressure:
L),1\.f.A19<
~

physical

features;

Bad physical
features;
A history of illness, hazardous
mining.;

Normal

occupation

weight

and

e.g. coal

~V\.~cM/L'!..!:-3)

",
.1

..,Ir

MORAL

HAZARD

.1

'~
C!:

'", ,

61
I

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,.1

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It relates
insured.

to the attitude

It is just as imporiant

and conduct
as physical

of the person

hazard.

;
;.

The insured' (the person or firm insuring);

Bad.
moral hazard on the pari of the insured is to submit f9ls.e
or exaggerated
claims or where required information for
..'

assessing the risk is withheld (concealed)

misrepresented
deliberately or innocently.

;J

or

Poor moral hazard may be carelessness

i.e. the
insured fails to take reasonable ca.re to prevent loss or
damage to his property or safety of his employees
and the
I
.
third party. Where the risk is"very high Insurer will. not

accept the same.

Employee;
Where the employer/employees
relations
are poor or ages are low, employees will ,hot be loyal and
risk will be high such as willful- fire -raising, vandalism etc.
,

I
.:

Society;
Society can a1so Influence the level of risk
and the incidence of claims, such as vandalism or wilfful
fire. :Society is now more cautious

..

about their rights:

ANAL YZINGRISK
Frequency
and severity;
When we evaluate a risk.
we must be clear that it incorporates
both he frequency
with which an event may take place and the severity of
each incident which does happen. Chemical plant is' very ..I
risky and an example of severity of loss because when
loss does take place. ,it involves a very high financial loss.
Converse)y,.' in a large departmental
store the breakage of
glass window can happen frequently and aggregate cost
of broken glass is high,
The concept of frequency ~nd severity is very
impoliant in the insurance world, i.e. there is a high

62

1~.~'

!
i
i

gr~~'1'1

'

;!

,~,

"

frequency

high

of

low

severity

severity

incidents

':

low

fre9~ency

o~:!~~'::;~:;~::;:-:f~---

incident~,J:'1~

6"

andll\a

6"1,,\'", Go'~'co ,)

',I

of,

-41

't

!I'

ut'~

Probability
likeliho~d

-;

theory;

that

measuring

given

t~ing.s

the

.
earthquake,
period.
Likelihood

it is less

Probabilities

will

likelIhood

motor

It can

of death

at a certain

accident,

to occur,
likely

to

the

occur

measure

happen.

plane

is measured

it is certain

on

Grash

a scale

probability
than

be

an

, -

~ppli.ed

in ..;

age,

etc:

a fire;,

within

fromO

is 1,
event

the

to

1 .Where

If probabilIty

having

..

is 0.2

a prob'ability

of 0.9.
I

Relative
risk

frequency;

is that

known'.
past

total

Such
data

example

commercial

accidents

the

available

on

vehicle

and

average

~ach
v~hicle

experience

own

business

measure

understand

.,

risk;

legs

on

'nature

this

a collision

of the

50

experience
next,

y~ar

~~tP)

It is an

risk

were

there

may

few

events,

such

risk

.e.g.

etc.

The

the

For

there

using

insured

to' help

of likelihood.

the

has

the

1500

or very

In certain

exist

is based

analyzing

In certain'cases

aspect;

probabilities

year

0.0333..\-l.~

stars'

Psychological

where

past

having

of London

meC;:isure

of

By

is not

industry.

a fleet

available

film

at by
and

the

pro.bability;

fingers,

a person

arrived

year.

1 QOO i.e:

Lloyds

pianists'

over

in measuring

outcomes

insurer

is ope(ating

by

past

the

insurer

j Subjective

occurred,

with

problem

possible

are

of one

divided

main

of all

speculations

an

no.t be

The

number

probability

is 50

I;

.'

, ,,'

factor,

circumstances
us,

~e

whole
and

risk

important

how

even

often

assign

our

of insurance

statistics
to which

enable
we

to

are

exposed.

63

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IX;

Chance;

You will not find talking

people

about the

xl,.
-J,, ..
:1

(risk of winning the football match', they will say 'chance of

winning the match'. Similarly peop1e normally refer to the
risk of unemployment
rather than the chance of'

.!:

unemployment.

..
ITHE-- RISK MANAGEMENTY

PROCESS

.,

,
,

Risk management
activities occur before, during, and
after losses. More planning is done before losses occur.
,

The risk manage.ment

steps;

process

requires
.

the following

.,

-.I

.Step

one;

Identify and measure

potential

exposure.

loss

"
",:e\..$~eelb-twq~ ~
o.se th~ most efficie'nt m~thods
I ,,,In..~ltt''1 )?ontrol~g
ana financIng loss exposures
and'
I
i

Implement them.
.Step
three; Monitor
'P]L

'.
outcomes.ll~~~"'~~':")

of

1Y\e..\.~\&~'S\"'>
~~"-~~)

.~~ tt1is 'p~int we can provide a mor~ comprehensive

definition of risk management.
An ongoing process that
requ.ires the 0~ganizat10n to identify th'e level of risk it .
wants to maintain, to identify the risk it currently retains,
and to make insurance and other financial arrangements
to make the desired and the actual level of risk the same.'
,

Step

one;

.,

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Identification

and

measurement

of

.:

exposures')

Loss begin's with categorizing

four cl~sses;
.Direct
property
.Losses

'.'
losses.

of income
arising

..~~
I""'-D-C~

and extra expenses

property loss. t~~~~~

.Losses

b~)

the possibilities

into
~

~\"(~

following

from lawsuits.

~~ \'~

\.,~~'

c.

64

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,':,,'" , ',:
.Losses

jj

caused

retirement

by the death,

disability,'

..,

or unplanned

of key people.

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rt must be noted that before a loss occurs,

measurement
is merely an estimate. Not all pre

..-

;..Ioss e~timates will reflect accurately the actual amouoht of,

..
damagesoor the actual expo~_ure to'ioss. '}o-::~';>""~Ot)).
o\<'I:..'\~'Lo} ~;J.
"

~
Direct

,
i

Property

-<~~CAJ'\JI;-~~

losses

~'~

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:

Risk managers can identify potential direct property

losses in different ways. A walking tour of a factory, store,
or hospital can reveal many ';)f the propeliy loss
exposures.
Risk managers often arrange regular
interviews with knowledgeable
employees
such as the

production

manager

or accountant

to identify

significant

.changes
in property h01dings. The risk m~nagement
procedures
manual should establish a system for notifying,
the risk management, department when property is
acql,jired or sold. ..~,.f2:jt~~~,1
,'I,~~i~'
Checklists;
many insurance organizations
provide a
property checklist that may, be used to identify and value
potentialo property los,ses. ,0'1~ 0 ,q~,.. c.tAt~"~p.~.

Property insurance
Identify
.Owned

i
I

and value;
buildings,

checklist

equipment,

and land

\
!I '

.Property
.Stationary

leased from others

inventory
(average
"

.Property

under

construction

or leased

vehicles.

.Owned

Identify

special

Propertvis

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,
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ft,

,,'
1 .',

'J!(

.~~;,
~
,;:

'" ,

perils

cost)

tow,hich

exposed;
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-~-~-.

':~~"~~C-

c:,

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.-

.Terrorism

!) ..Radiation
.f

';.
..

.Explosion
.Flood

..Earth

.Theft..

movement

.Contamination
~
\) ',,- ~

Flow Charts

.~'

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e~~)
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~~
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A flow chart graphically represents'the

productiC?n.or
distribution process. Flow chart~ analysis displays the
firm's re1ations with suppliers, customers,
utilities, an.d
.
modes
of
transportation.
Risk
mangers
analyze
flow
charts to spot production bottlenecks,
sole'-source

suppliers, or concentration
of valuable property. .Flow
.
charts also help reveal the consequential
impact of losses.
L0ssoflncome,

'
.

Indirect
losses; These are more difficult to identify
than direct property losses. We can'see a machine and
measure its, but we cannot s~e the (ost profits if the
machine IS unavailabfe for three months. Often it is difficult
to estimate how fong a machine or a building will be
unavai1able after a loss, or whether a loss will occur during
a busy season or a. slack periO9. Despite this it is the
responsibilities
to the risk manger to make careful
estimates

and judgments

about the potential

size of dIrect

.1

losses.

.!
!
I

Direct
The risk
should
ask informed
people
how losses;
long it would
takemanager
to resume
physical

.operations. of a total or parti~lloss

occurs~ The ac.countant
should estimate how much Income would be lost In

\i

66

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addition
would

to how much fixed and continuing

occur

before

normal

operations

expenses

.'
",,:'~ ,,:. 4

resume.

-"

Liability

losse~~~;:~':\

u,.~~ ~

.e...;)

Liability losses arise from three sources; .

.An
organization
responsiple for negligently

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somebody
must pay legal damages
court to the injured party.

.1
-\

injuring

awarded

by a

.Cost
of legal defense. A defense can be expensive
even in cases where a court.. finds the 'victim's claims
groundless,
false or fraudulent.
In some cases, the
legal defense costs more than the damages awarded
to parties claiming injury.
.The
cost of loss prevention arising fr,om potential

Ii
I

legal liability.
i
,

Ivpi,al ~ources
af lia~i/~tv las~
.
.Bodily
or personal Injury" to ,employees,

clients,

or guests.

.Property
others.

damage

.Intentional
including

injury to people
illegal accusation

to the real dr personal

/.

~
j"

i r:
I

property

to

or their reputation,
or restraint of alleged

shoplifters.
.Wrongf.u1
hiring, termination,
/

customers,

sexual

harassment,

or

in.vas!on o~ pr~~~cy ?f. employees .or jo~appl.icants.

VIcarious liability arising when a firm hires or
autho:i~es anoth~r party to act on its behalf and this
p~rty In~ures a ~~Ird party.

~,{"t>t(.ct.~.,v-ct} Mc;.- C~n't

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f

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Step two: Lass control

an.d risk financinQ
.
Loss control;
It is designed to reduce loss cost and
1
include the following risk management
tools; risk (~6 C::, t:.~ 5"~)
avoidance,.

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i
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,[

loss
(i

prevention,

.and loss

reductio,n.;

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67

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,
Risk avoidance;
Sometimes
the best method of
"
dealing with an exposure to loss i.s,to avoid all possibility
of the loss occurring', It means the chance of loss'has
been eliminated.
In practice, it may mean not i.ntroducing
a new product, ending the production ,of an exi$ting
prod'uct, discontin~ng
some operations,
or selecting a
business location where a parti_c_ular peril is not present,

.I

/.\"I,~~ ~~ Some risks are unavoidable.

For example, the risk of
~ .,)'D'~ bankruptcy,
the risk ofa liability suit, or the risk of ".
SZ;premature death cannot be avoided by firms or
,
!.

individuals.
The exposure
not eliminated.

to loss can often' br reduced

..,..

but

Loss prevention;,
Su'ccessful.loss
prevention
activities lower the frequency of losses. Exa~ple
of'loss
prevention activities include,.employ
security guards in
banks, driver training and , safety education
programs, and
.
warning printed on drugs and dangerous chemicals.
Loss

reduction;

Successful

loss reduction

activities

reduce loss severity. Despite the best loss prevention

efforts, some losses occur. Loss reduction activities aim at
minimizing the impact of losses. For example a loss
reduction device is the automatic fire sprinkler system
This system is not designed to prevent fires, but to
prevent .the spread of fires (reduce severity).

I
!

;
I

i
!

RiskFinancin~

"

Risk financing determines

when and by whom loss
CO$ts are borne~ Risk financing includes the fol1owing
i
!

alternatives;
.Risk
assumption
.-, ."" I.t'

tr " ~ c:~'"

.r:-o:.!~1\.

~".i\CI

.Self-Insurance

O S-'~ Ci'I/I
ILJVL;1

t I.. -,..,
:
"O"III.""\IJIQII\..JG

and financed

""' ...~

risk retention

68

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c;.

-:

..,.
-' ~ ,:.~.....,
.

c.

.
.on

drugs and dangerous chemicals.

Loss

reduction;

Successful

loss

reduction

activities

reduce

loss

severity. Despite the best loss prevention efforts, s,ome losses occur. Loss
reduction activities aim at minimizing the impact of losses. For example a
..loss

reduction device is the automatic fire sprinkler system This system is

not designed to prevent fires, but to prevent the spread of fires (reduce
severity).

Risk FinancinQ
Risk financing determines when- and by whom loss costs are borne. Risk
financing includes the following alternatives;
.Risk

assumption

.Risk

transfer other than insurance

.Self.insurance

and financed risk retention

..Insurance.
.~I)

Risk assumQtion;
It means that consequences of a loss will be borne by the party exposed
to the chance of loss. Business firms assume risks when;

.Loss

costs are small and funded from current cash flow.

.Loss

exposures are retained and funded with a cash reserve.

.Loss
exposures are retained and recognized in arf-ttnfunded
accounts.
s~_h,
~~~
0..\~eIt-~-~
.A
self insurance or finite risk program is operated.
Firms assume many risks because the consequences
not be costly enough to justify

reserve
~'6 fu

.'

~~
1&)\

of a loss would

any_other risk management decision.

For

instance, most students assume the risk that their books will be stolen or
misplaced. If such a loss occurs, the students bear the cost of replacement.
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such as hand tools or plates used by a restaurant. The ability to assume risk.
is a function of a firm's financial capacity; (Py b-1ti1.1f,.., w)"tt~)

I
I

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~

Self-Insurance;

Risk assumption

deliberate or unplanned, should n~t be

confused with the concept of self-insurance.

adequate financial

arrangements

..

'i

Self insuran~e plan implies that

".

have been 'made in advance to provide

funds to pay for los~~s should they occur..

f1 j(1)/JIIl-~U ~jIW"t~::;~,

The Capfive

~~-

/tfsurance

Company;

-I

One approach

t,o self insurance

'

involves the use of a company formed to write insurance for a'parent, called
a captive insurance company. One motive in forming a captive is to save the
overhead and profits earned by commercial insurers.
to earn the investment

income

available

insurance

appeal

to

companies

A second incentive is

on advanced funding.

some

organizations. see one or more of the following

organizations

Captive

because

the

potential advantages;

.l!!:!.E-roved Loss Prevention Ince.nti.v.es: This offers a chance to

reap directly the benefits of successful loss control.

.!

.l'EE!QY.ed-Claims
s~ttlement~
This advantage includes the
ability to cover claims or exclude claims with more flexibility

j
.~

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than a commercial insurer.

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