INSURANCE & RISK MANAGEMENT

MBA- Finance Specialization: 2nd Module

Jinuachan Vadakkemulanjanal
Vimal Jyothi Institute of Management & Research, Chemperi PO, Kannur Dr , Kerala-670632
www.vjim.ac.in; jinuachan@gmail.com; +91-9447373415; 04602213399; 2212240
INSURANCE & RISK MANAGEMENT
MBA3E33 2nd Module

SEMESTER III- FINANCE-Elective Course

Jinuachan Vadakkemulanjanal
Vimal Jyothi Institute of Management & Research,
Chemperi PO, Kannur Dr , Kerala-670632 www.vjim.ac.in
jinuachan@gmail.com; +91-9447373415; 04602213399; 2212240
 Module -2
• Risk Retention and Transfer
• Pooling
• Loss Exposure
• Legal Aspects of Insurance Contract
• Principle of Indemnity, Estoppels, Endowment,
Insurance.
 Objectives
• To get a fare knowledge about the insurance contract
• To know about the Risk Retention and Transfer modes
• To understand about the insurance contract
• Understand the principles of insurance
• To get a real time understanding through the company
related assignments
 Risk Retention and Transfer
Risk Retention means that the firm retains part or all
of the losses that can result from a given loss .
Retention can be either active or passive.
• Active risk retention means that the firm is aware of
the loss exposure and consciously decides to retain
part or all of it.
Eg collision losses to a fleet of company cars.
• Passive retention is the failure to identify a loss
exposure, failure to act, or forgetting to act.
Eg. a risk manager may fail to identify all company
assets that could be damaged in an earthquake.
 Risk Retention when
• No other method of treatment is available . If the
exposure cannot be insured or transferred, then it must be
retained
• The worst possible loss is not serious .
• Losses are fairly predictable and can be bearable

Ref: p4 8, C h a p t e r 3 / I n t r o d u c t i o n t o R i s k M a n a g e m e n t
 Risk Retention
• Involves the assumption of risk
• If a loss occurs, an individual or firm will pay for it out
of whatever funds are available at the time

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 Planned Versus Unplanned Retention
• Planned retention
– Involves a conscious and deliberate assumption of recognized
risk
– it is the most convenient risk treatment technique
• because there are no alternatives available, short of ceasing
operations
• Unplanned retention
– When a firm or individual does not recognize that a risk exists
and innocently believes that no loss could occur
– Sometimes occurs even when the existence of a risk is
acknowledged
• When the maximum possible loss of a recognized risk is significantly
underestimated
-Accident cant affect the BMW; client law suit for compensation 8
 Funded Versus Unfunded Retention

• Un funded retention: Many risk retention

strategies involve the intention to pay for losses
as they occur
– Without making any funding arrangements in
advance of a loss
• Known as unfunded retention
• Funded retention
– Preloss arrangements are made to ensure that money
is readily available to pay for losses that occur

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 Funded Retention
a) Credit
– May provide some limited opportunities to fund losses that result from
retained risks
– not a viable source of funds for the payment of large losses
• Unless the risk manager has already established a line of credit prior to the
loss
– The very fact that the loss has occurred may make it impossible to
obtain credit when needed
b) Reserve funds
– Sometimes established to pay for losses arising out of risks a firm has
decided to retain
– When the maximum possible loss is quite large
• A reserve fund may not be appropriate
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 Funded Retention
c) Self-insurance
– If the firm has a group of exposure units large enough to
reduce risk and thereby predict losses
• The establishment of a fund to pay for those losses is a special form of
planned, funded retention
– Will not involve a transfer of risk
– Necessary elements of self-insurance
• Existence of a group of exposure units that is sufficiently large to enable
accurate loss prediction
• Prefunding of expected losses through a fund specifically designed for that
purpose
d) Captive insurers
– Combines the techniques of risk retention and risk transfer.
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ch12
 Determining Retention Levels
Each firm can determine its retention level based on..
1. Financial levels of operation
2. Assessment of probability and severity of risk
3. Nature of the business- passive, moderate, aggressive
4. PESTL analysis: Political, Economical, Social, Technological
& Legal analysis
5. Historical data/market portfolio analysis
6. The govt/agency regulations
http://rris-insurance.com/rr/
https://www.irmi.com/articles/expert-commentary/determining-.....isk-retention-and-risk-transfer
Decisions Regarding Retention: Financial Resources

1) A large business can often use risk retention to a

greater extent than can a small firm
– In part because of the large firm’s greater financial
resources
– Thus, losses due to many risks may merely be absorbed as
losses occur, without much advance planning
• Examples may include pilferage of office supplies, breakage of
windows, burglary of vending machines
2) The retention levels is decided by
– Total assets, total revenues, asset liquidity, cash flows, working capital,
ratio of revenues to net worth, retained earnings, ratio of total debt to
net worth
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 Decisions Regarding Retention
3) Ability to predict losses
– Although a firm may be able to retain the maximum probable loss
associated with a particular risk
• Problems may result if there is considerable variability in the range of possible
losses
4) Feasibility of the retention program
– If the decision to retain losses involves advance funding
• Administrative issues may need to be considered
– If the risk is likely to result in several losses over time
• There will be administrative expenses associated with investigating and
paying for those losses
– Administrative issues are of particular concern when a firm decides to set
up a self-insurance or captive insurer arrangement
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 Risk Transfer
• Involves payment by one party (the transferor)
to another (the transferee, or risk bearer) p-83T
• Transferee agrees to assume a risk that the
transferor desires to escape, (and is effected by
the law of large numbers)
•

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 Hold-Harmless Agreements
• Provisions inserted into many different contracts can transfer
responsibility to a party other than who otherwise bear it –3rd
one
• Also known as indemnity agreements
• Intent of these contractual clauses
– To specify the party that will be responsible for paying for various
losses
– Usually, no loss limit is stated

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Forms of Hold-Harmless Agreements
1. Limited form
-Clarifies that all parties are responsible for liabilities
arising from their own actions
2. Intermediate form
-Transferee agrees to pay for any losses in which both the
transferee and transferor are jointly liable
3. Broad form
• Requires the transferee to be responsible for all losses
arising out of a particular situation
– Regardless of fault

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Enforcement of Hold-Harmless Agreements

– Are not always legally enforceable

– If the transferor is in a superior position to the
transferee with respect to either bargaining power
or knowledge of the factual situation
• Attempt to transfer risk through a hold-
harmless agreement may not be upheld by the
courts
– Particularly true of broad-form hold-harmless agreements

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 Non Insurance Transfers..
a) Incorporation
• It is another method of risk transfer
• Incorporation is the legal process used to form a
corporate entity or company.
• A corporation is a separate legal entity from its
owners, with its own rights and obligations.
• Corporations are identified by terms "Inc." or
"Limited" in their names.
• Owners personal assets can’t be attached with Inc
 .. Non Insurance Transfers
b) Diversification
– Results in the transfer of risk across business units
– Combining businesses or geographic locations in one
firm can even result in a reduction in total risk
• Through the portfolio effect of pooling individual risks that have
different correlations
c) Hedging
– Involves the transfer of a speculative risk
– A business transaction in which the risk of price
fluctuations is transferred to a third party
• Which can be either a speculator or another hedger
• Eg Airline fuel hedging by future contracts
• Derivatives: Forwards, Futures, Options, Swaps
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 Risk Pooling in insurance
• It is used as ‘insurance’ 5,000 years ago, to protect shippers
against the loss of their cargo and crews at sea.
• “Risk pooling" refers to the spreading of financial risks evenly
among a large number of contributors to reduce its impact.
• Risk pooling in insurance is a practice where the company
groups large numbers of policyholders together to lower the
impact of higher-risk individuals by placing them alongside
lower risk ones.
• Health, car, home and life insurance firms practice risk
pooling model

Ref: IRM, Gupta, PK, Chap6.3

• Insurance companies also practice risk pooling,
which can provide protection to insurance
companies against catastrophic risks such as floods
or earthquakes
• Shares the expected losses on mutual agreement
• Advantages?
 Pooling – two person
• Jack and James bike riders. 20% chance of accident
which costs loss of Rs5000. Find out the pooling and
non pooling effect of probability and the expected
cost
Possible outcome Total Cost Loss shared by each Probability
No accident 0 0 0.8x0.8=0.64
Accident to Jack only ? ? ?
Accident to James only
Both met with accidents
Possible outcome Total Cost Loss shared Probability, p Expected cost
by one = p x cost
No accident 0 0 0.8x0.8=0.64 0
Accident to Jack only 5000 2500 0.2x 0.8=0.16 800
Accident to James only 5000 2500 0.2x 0.8=0.16 800
Both met with 10,000 5000 0.2x 0.2=0.04 400
accidents
 Loss Exposures
1.Property Loss Exposures
2.Liability Loss Exposures
3.Personal and Personnel loss Exposures
4. Income Loss Exposure
Legal Aspects of Insurance Contract
 Insurance terms
• Insurer 1st party
• Insured 2nd party
• 3rd party
• Premium
• Policy
• Subject matter
• Insurable interest
• Insurable risk
 Basic Principles of Insurance
Principle of Contract
1. Principal of Utmost Good Faith- Ubrrima Fides .
2. Principle of Insurable Interest.
3. Principle of Indemnity.
4. Principle of Subrogation/contribution.
5. Principle of Loss Minimisation
6. Principle of Causa Proxima
7. Principle of Subrogation
 Essential elements of a valid contract.

• There must be contract between two parties i.e.

insurer and insured.
• The contract must be in writing.
• The insurance policy is printed, stamped, signed my
the insurer and handed over to the insured.
• It should have a valid offer, acceptance and
consideration.
• There should be a lawful object.
 1.Principal of Utmost Good Faith
-Ubrrima Fides
• Both parties, insurer and insured should enter into
contract in good faith
• Insured should provide all the information that
impacts the subject matter
• Insurer should provide all the details regarding
insurance contract
Eg: - Alex took a health insurance policy. At the time of taking policy,
he was a drunkard and he didn't disclose this fact. He got liver
cancer. Insurance company won't pay anything as Alex didn't reveal
the critical facts.
 2.Principle of Insurable Interest
• Insured must have the insurable interest on the subject
matter
• In case of life insurance spouse and dependents have
insurable interest in the life of a person. Firms also
have insurable interests in the life of it's employees
• In case of life or marine insurance, insured must be the
owner both at the time of entering of entering into the
insurance contract and at the time of accident.
 3.Principle of Indemnity

• Insured can't make any profit from the insurance

contract. Insurance contract is meant for coverage of
losses only
• Indemnity means a guarantee to put the insured in
the position as he was before accident
• This principle doesn't apply to life insurance contracts
 4.Principle of Contribution
• In case the insured took more than one insurance
policy for same subject matter, he/she can't make
profit by making claim for same loss more than once
• Principle of Contribution is a right that an insurer has,
who has paid under a policy, of calling other interested
insurers in the loss to pay or contribute to the
payment”.
5.Principle of Loss Minimisation/Mitigation of loss
• When peril takes place, the policy holder must do
every thing to minimize the loss and to save what is
left. This principle makes the insured more careful in
respect of this insured property.
• He should act to reduce the loss in all possible ways
before-during-after the peril
• Eg: if one house burned, call fire force and people
near by
 6. Principle of Causa Proxima
• Word "Cause Proxima" means "Nearest Cause"
• An accident may be caused by more than one cause. In
case property insured for only one cause. In such case
nearest cause of the accident is found out.
• Insurer pays the claim money only if the nearest cause
is insured
 7.Principle of Subrogation
• Principle of subrogation is a Legal principle under which an
insured party surrenders its rights against a third party to the
insurer after claiming and receiving a compensation for an
insured loss.
• After the insured gets the claimed money, the insurer becomes
the possessor of the things insured.
• After making the payment insurance claim, the insurer becomes
the owner of subject matter.
• Eg: After paying the total loss, the scrap cant be sold by the one
who owned it
• A has damaged B’s motor car negligently. If he pays B’s loss in full. B cannot collect the
same from the insurance company. On the other hand if B applied to his insurance
company for indemnity under his policy, he will not be permitted to collect the
damages from A. In the latter case the insurance company will be entitled to collect
that amount.
 Estoppels
• Estoppel is a legal principle that prevents a person from
alleging facts that are contrary to his previous claims or
actions.
• In other words, estoppel prevents someone from arguing
something contrary to a claim made or act performed by
that person previously.
• Eg: an insurer that has repeatedly accepted late premium payments
from an insured may be estopped from later canceling the policy on
the basis of nonpayment because the insured has been reasonably
led to believe that late payments are acceptable.
 Endowment Insurance

• An endowment policy is a life insurance contract

designed to pay a lump sum after a specific term (on
its 'maturity') or on death.
• Typical maturities are ten, fifteen or twenty years up
to a certain age limit.
• Some policies also pay out in the case of critical
illness.
 Assignment: Insurance firm- 2
• Select an insurance firm and provide the basic details
about it.
• Identify the different categories of Life and General
insurance
• Identify and give a brief on different plans of the firm
you identified.
• Submit the Print as continuation to the part 1.
• Last date:
 Thanks for using this slide.
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Jinuachan Vadakkemulanjanal
Vimal Jyothi Institute of Management & Research,
Chemperi PO, Kannur Dr , Kerala-670632 www.vjim.ac.in
jinuachan@gmail.com; +91-9447373415; 04602213399; 2212240