TOPIC ONE: INTRODUCTION TO RISK MANAGEMENT AND INSURANCE

We start our lesson by defining and explaining three basic concepts critical to understanding both
insurance and risk management.
1. THE CONCEPT OF RISK

What does risk mean to you? Risk is a word that has more than one meaning. It is a term that can mean
different things depending on the circumstances and the context in which it is used. Here are some of the
meanings it can assume.

(i) Uncertainty

The primary meaning of risk as applied in risk management and insurance is that of the uncertainty of an
outcome in a given situation. The key word here is “uncertainty” It is the doubt whether a given event
will take place or not. The greater the doubt or uncertainty, the greater is the risk. When are you
uncertain? When are you in doubt? And so when are you at risk? In this context, you can only be at risk if
you face an event which may or may not occur, if there are at least two or more possible outcomes from
the event, and you cannot determine in advance which one of the two or more possible outcomes you
will actually experience.

There is no risk, no uncertainty or doubt in a situation where there is only one possible outcome. Or where
we can tell in advance which outcome shall be experienced because in such cases there will be no
uncertainty or doubt about the expected outcome.

Uncertainty or risk is only relevant if one of the expected possible outcomes is a loss. A risk is not
significant if it cannot cause us a loss of any kind. Risk therefore has two main things to it, uncertainty of
occurrence of an event and a possible loss of some kind from the event. Risk management and insurance
is therefore more concerned with those risks capable of causing losses.

So what is a loss? A loss is the unintentional or involuntary parting with something of value. A loss may be
either financial or non financial and could involve both tangible and intangible assets.

Some situations of uncertainty that could give rise to risk and loss include

(a) The negligence of participants in a certain activity or the negligence of others.

(b) Events that may be foreseeable or not foreseeable for now.

(c) Hazards or conditions arising out of ownership or operating in premises.

(d) Performing certain activities or participating in certain activities.

 (e) Failure to perform certain activities such as proper maintenance, inspection, supervision,
controls, etc.

(f) Failure to provide warnings on existing dangerous conditions.

(g) Poor administrative structures.

(h) Environmental factors such as political instability, socio- cultural practices, natural calamities, etc.

Can you now list some specific loss causing events which could occur in the situations (a) to (h) above?

(ii) Chance of loss or the probability of occurrence of a loss.

We have already in the previous section defined risk as uncertainty of occurrence of an event. But the
term risk can also mean something else. It can also be defined as the chance or probability of occurrence
of a loss. This is the long run relative frequency of a loss. The probability or chance of occurrence of a loss
varies between 0 and 1. The 0 position says there is no chance of a loss occurring. At the other end 1, the
chance of loss is 100 percent because the loss is certain to occur.

The chance or probability of loss may be conveniently expressed as a fraction, and it indicates the probable
number of losses out of a given number of exposures and expresses it as a percentage. Expressed as a
fraction, the numerator represents the probable number of losses, and the denominator represents the
number of times that the event could possibly occur.

In this context, situations with a high probability of loss are said to be riskier than those with a low
probability of loss. The risk is greater if the probability of loss is higher.

Normally when we say that something is very risky, we are in essence saying that the probability that it
will cause a loss is very high. Qualitatively, risk is proportional to both the expected losses which may be
caused by an event and to the probability of this event. Greater loss and greater event likelihood result in
a greater overall risk.

Take note that if risk means uncertainty according to our first definition then risk does not exist where the
chance of loss is either 0 or 1. This is because there is no doubt or uncertainty about the expected outcome
in the two positions. The outcomes in the two positions are already definite and certain.

(iii) The subject matter insured in a contract of insurance.

The term risk can also refer to the object covered or insured in a contract of insurance. It could be a house,
a car, a life, etc. for every contract of insurance there must be something being insured against loss. This
becomes the subject matter of the contract and can be referred to by the insurers as the risk.
(iv) A peril

Risk can also mean a peril. This is the immediate cause of a loss such as a fire or earthquake. Each loss that
occurs must have a cause. These causes such as accident, illness, theft, fire. Etc. is known as peril or risk.
So when we talk of the risk of fire, or theft, etc. In insurance policies it is common to find a section dealing
with “insured risks” or “insured perils” and then listing the risks or perils. These would simply be some
possible causes of loss which the insurer is accepting to cover. Note that the insurer is only liable to
compensate for a loss if the loss is caused by a peril or risk covered in the policy.

(v) The dispersion of actual from expected results.

This is the statistical definition of risk as measured by the standard deviation, which is the most widely
accepted measure of risk. It is a figure that more or less measures the degree or the level of in a given
situation. It is a measure of risk that is objective.

In conclusion we have seen that the term risk can mean five different things depending on the
circumstances and the context in which it is applied. You should now be able to explain the five different
meanings.

CLASSIFICATIONS OF RISK

We started our discussions in this lecture by giving meanings to the term risk. We saw that the word risk
can mean five different things. Let us now look at the different classes of risk. We have thousands if not
millions of risks that could cause losses. All these risks can broadly be classified into two main categories.
These are pure risks and speculative risks.

Pure risks

A pure risk exists when there is uncertainty as to whether a given event will cause a loss or not. The
occurrence of the risk may cause a loss only. There is no possibility that the event may cause a gain or
profit. There are only two possible outcomes in a pure risk situation. The risk can cause either a loss or no
loss. There are only two possibilities that could result from the risk and that it is that either causes a loss
or things stay as they were. Can you think of any risk of this nature can only either cause a loss or no loss?

Fire in a given building is a pure risk. Within any given period of time either fire incident occurs in the
building or it does not occur. There is no third possibility. Death is a pure risk, by the end of the year, there
can only be two possible outcomes. Either death has occurred or the person is still alive. There are many
others such as accidents, earthquakes, theft, etc. Can you list some other pure risks?

The other main characteristic of a pure risk is that in fact differentiates it from other risks is that it has no
element of a profit. There is no chance that the risk could cause a profit as one of its possible outcomes.
Pure risks occur naturally and are not created by those exposed to them. They can generally be handled
through the practice of insurance.
 Speculative risks:

Speculative risks involve events which may produce either a gain or a loss. The main characteristic of a
speculative risk is that there is an element of profit. There is a chance that the risk could result in a profit
as an outcome. Speculative risks are generally associated with business investments where people invest
in the hope of making profits. Who is a speculator? This is one who buys today in the hope of selling
tomorrow at a profit. Speculative risks may also be associated with betting or gambling where there is a
chance of ending up with profits. Speculative risks are not naturally occurring. They are self-created and
voluntarily taken by those who want to make profits.

We had earlier said that all risks can be classified into two categories. Any risk will be either a pure risk or
a speculative risk. However these two primary classifications, risks can be further be sub classified into
other sub classes. It is possible for a risk to be a pure risk or a speculative risk and at the same time also
fall into other sub classes such as

(a) Fundamental risks

These are risks that arise from causes outside the control of any one individual or even a group of
individuals. The effect of fundamental risks is felt by large numbers of people. They are impersonal in
origin and widespread in effect. Examples include earthquakes, floods, volcanic eruptions, and other
natural disasters. They are not however limited to naturally occurring perils. Social change, political
intervention, and war are all capable of being interpreted as fundamental risks.

(b) Particular risks

They can also be referred to as personal risks. These are personal in both cause and effect. All of them
arise from individual causes and affect individuals in their consequences. They are risks faced by
individuals and their families. They are in areas such as loss of earnings, death, disability, liability suits,
medical expenses, loss of physical assets, etc.

(c) Objective risks

This is the measure of the degree of variation in the proportion of actual from expected events. The
probable variation of actual from expected experience. It is observable and measurable. This proportion
declines as the number of observed events increases. It follows from the law of large numbers.

(d) Subjective risks

Subjective risk refers to the mental state of an individual who experiences doubt or worry as to the
outcome of a given event. It is the psychological uncertainty that arises from an individuals or state of
mind. It is the uncertainty of an event as seen or perceived by an individual. This perception depends on
the individual’s attitudes towards risk. Objectively the risk may be small but the person sees it as a big
risk. Alternatively it may be true that the risk is a big one but the person sees it as a small risk. An objective
risk may be the same but different people may see it differently depending on whether they are risk averse
or not.

(e) Static risks

This refers to a risk that does not change much overtime. It stems from an unchanging society that is at
equilibrium. Pure static risks include the uncertainties of due to such random events as lightning,
windstorms and death. Speculative static risks may be experienced in undertaking a business venture in a
stable economy.

(f) Dynamic risks.

These are risks arising out of changes in society. They are risks resulting from changes in the economy.
Urbanization, social crimes, changing attitudes, etc. are some of the factors that could cause dynamic
risks.

We have noted that there are two basic classes of risk. There are pure risks and speculative risks. We have
also seen that both classes of risk can also at the same time be classified into other classes. It is possible
for example for a risk to be a pure risk and at the same time be a particular or personal risk. it is not
therefore a must that a risk belongs to only one class.

(g) Political risks

This refers to decisions of the government that may impact negatively on the business as well as the
stability of the political systems in place in a particular country. Examples include; cancellation or non-
renewal of licenses, expropriation or confiscation of the business, imposition of duties and even banning
of products, imposition of exchange controls, political instability, etc.

(h)Operational risks.

These are risks resulting from inadequate or failed internal processes, from failed systems, from failures
of people, and external events. Examples include; technology failure, business premises becoming
unavailable, inadequate record keeping, poor management, and lack of supervision, accountability, and
control, as well as third party fraud, etc.

(i) Credit risks

This is the risk of loss due to a debtor’s nonpayment of a loan or line of credit. This involves either the
principal or interest or both.

THE IMPACT OF RISK

In the previous sections, we looked at the different meanings that the terms risk and hazards can assume.
We now need to examine the effect of risks and hazards on enterprises.

Businesses always face the uncertainty of losses that may never occur. Each day, risks and hazards
threaten business enterprises affecting them both positively and negatively in the some ways. Risks can
also create opportunities for a business enterprise. But now we examine the negative impacts of risks on
a business enterprise. The following are some of the negative consequences of risk on a business.

(1) Cost to business

(i) Causing losses. Risks cause actual losses. The actual losses may serious and crippling to a business or
cause great financial hardship. The losses caused by risk may direct losses resulting from the occurrence
of the risk or indirect losses such as loss of profits, loss of life, and disability.

(ii) Interrupting business operations

(iii) Reducing profits

(iv.) Limiting ability to compete and slowing growth.

(v) Uncertainty. Most businesses face threats of losses that may never occur. This causes uncertainties in
regard to the possibility of a loss.

(vi.) Fear and worry. Even if no loss ever occurs as anticipated, at least two factors add to the cost of
uncertainty. These are fear and worry. The time spent thinking about real or imagined chances of loss is
expensive considering the many other things that could be done if there were no fear of loss. The cost of
loss of peace of mind is great indeed.

Fear and worry may stop a business from engaging in certain profitable activities and otherwise alter how
it conducts its operations.

(vii) Less than optimal use of resources. Investments are frequently influenced by the risks to which they
are exposed. Some activities or investments are completely avoided because the exposure to loss is very
high.

The amount of money “put away for a rainy day” is not readily available for investment and cannot be
invested in a much more productive capacity.

Investments may be diverted to more liquid or safer types of assets than are really necessary. This results
in reduced earnings which is an additional cost of risk.

(vii) short- term planning. Risk causes the tendency to concentrate planning in the near future, rather than
on the significant benefits of long range planning.

METHODS OF HANDLING RISKS

The following five basic methods or techniques can be used in the management of risks.

i) Avoidance
A person who is exposed to risk can handle the situation by avoiding any activity with which the risk is
associated. It involves not performing an activity that could carry the risk. This tends to eliminate the
chance that the person will suffer loss. It may also mean avoiding any property with which the risk is
associated. But it must be noted that some risks like death are unavoidable. It is also necessary to take
some risks in life to develop and prosper. A person who avoids all risks in life will never achieve anything.
Avoiding risks also means losing out on the potential gain that accepting (retaining) the risk may have
allowed. Not entering a business to avoid the risk of loss also avoids the possibility of earning profits.

ii) Prevention and risk reduction

This technique involves taking deliberate measures to prevent the risk from physically causing a loss. It
also includes measures intentionally to reduce the severity of the loss or the extent of loss. Examples
include putting money in a safe to prevent thieves from accessing it. Having in place a sprinkler designed
to put out a fire to reduce the risk of loss by fire.

iii) Risk retention/assumption/acceptance

This method involves accepting the loss when it occurs. It can also be referred to as acceptance of risk or
assumption of risk. Risk retention can be in the form of simple assumption which means the risk is ignored
and the person goes about his/her business as if the risk does not exist. You probably simply assumed
death today and went about your duties as if the risk does not exist. It can also be in the form of self-
insurance. In this case there is a financial plan to deal with the loss if it occurs. Risk retention is a viable
strategy for small risks where the cost of insuring against the risk would be greater over time than the
total losses sustained. All risks that are not avoided or transferred are retained by default. This includes
risks that are so large or catastrophic that they either cannot be insured against or the premiums would
be infeasible like war.

(iv)Risk transfer

Means causing another party to accept the risk, typically by contract or by hedging. Insurance is one type
of risk transfer that uses contracts. Other times it may involve contract language that transfers a risk to
another party without the payment of an insurance premium. Liability among construction or other
contractors is very often transferred this way. On the other hand, taking offsetting positions in derivatives
is typically how firms use hedging to manage risk. Outsourcing is another example of Risk transfer where
companies outsource.

2. THE CONCEPT OF HAZARDS

Meaning of hazard.

The term hazard refers to any condition that has an impact on risk in the following two ways. First, it is a
condition that increases probability that a particular risk will physically cause a loss. It is a condition that
increases the frequency or incidence of loss or makes it more likely that a risk will physically cause a loss.
Secondly, a hazard is a condition that increases the extent of loss. It is therefore a condition that ensures
that any loss that the risk causes will be more severe or serious than normal. This means that it increases
the size of the loss resulting from the occurrence of risk. A hazard therefore increases both the chance of
loss and the severity of loss. A risk on its own may not cause a loss or the loss it causes may be small but
combined with a hazard there is a much greater chance that the loss will occur or that the loss that occurs
will be much more severe than normal under the circumstances. It is important therefore to give as much
attention to hazards as is given to risks. Three different types of hazards can be identified. These are

Physical hazards

A physical hazard is a condition stemming from the material or physical characteristic of an object that
increases its chances of suffering a loss through a particular risk or which makes the loss resulting from
the risk to be more severe than normal in the circumstances. Consider the risk or peril of collision of motor
vehicles. Some physical conditions that make a loss from a particular risk more likely. Examples are;
collisions involving motor vehicles more likely to occur if the physical condition of the road is wet and
slippery; if the physical condition of the motor vehicle is that it has faulty brakes or if there is a fog, etc.
The chances of suffering a heart attack or stroke are higher if the physical condition of the person is that
he has high blood pressure. A building could be made of wood concrete blocks. the physical characteristics
of wood makes it more likely that a fire breaking out will have more severe consequences than that
breaking out ii a concrete block building. The same would apply where a building is roofed with either
makuti or grass. So the physical qualities of an object will increase its chances of suffering a loss through
a particular loss or may make a loss that occurs to be more severe than normal.

Moral Hazards

This refers to certain personality characteristics that increase both the incidence and the extent of loss.
This is a hazard that is only unique to human beings, who have a sense of judgment and is able to tell what
is right to do and what is wrong to do. It is a question of whether person has moral or immoral tendencies.
A moral hazard exists where a person has immoral tendencies. Such a person has certain personality traits
that lead to dishonesty and lack of moral integrity. This increases the chances that a loss will occur because
the person is motivated to dishonestly cause his own loss intentionally in order to obtain financial benefit.
The loss may also be more severe either because the person does not mitigate it and so ends up with a
bigger loss or because the person exaggerates the actual loss in order to obtain a bigger compensation
than the loss actually suffered.

Morale Hazards

This refers to certain mental characteristics that increase both the probability of occurrence of loss and
the severity of loss. It is essentially a mental state. A person who is motivated may have a very high morale.
Such a person becomes mentally very active and reaches a very aggressive mental state. This could lead
to recklessness in the way the person does certain things. There is a greater chance of loss where a person
is in an aggressive and reckless mental state. The person fails to exercise due care in performing activities
which lead to the occurrence of loss. In Kenya many accidents have occurred on our roads simply because
the driver was very reckless and aggressive in the way he or she was driving. Many industrial accidents
have occurred simply because an employee was reckless in the way he was handling a particular machine,
thereby causing injury to himself or to other fellow employees. A person may not be motivated and in a
state of low morale. Such a person is not in an active mental state. He is in a mentally lazy state. He does
not exercise keenness in doing certain things. Such a person becomes careless in the way he is handling
things. This will lead to more losses occurring. An overaggressive mental state or a mentally lazy state
therefore leads to more losses due to either recklessness or carelessness.

3. THE CONCEPT OF INSURANCE

MEANING OF INSURANCE

From a functional point of view, insurance can be defined as a social device or mechanism to spread losses
caused by a particular risk over a large number of people who are exposed to it and who agree to come
together and contribute funds to cover themselves against the risk. Insurance serves as a mechanism for
transferring losses falling on an individual or his family to a large number of persons each bearing a
nominal expenditure and feeling secure against heavy loss. It is the equitable transfer of the risk of a loss,
from one entity to another, in exchange for a consideration. In a contractual sense, insurance can also be
defined as a contract in which a sum of money known as a premium is paid in consideration of the insurer’s
incurring the risk of paying a large sum upon the occurrence of a given risk. Insurance is a contract in
which one party (usually an insurer) agrees to pay another party (usually the insured) or his beneficiary a
certain sum upon the occurrence of a given risk. The insurer is usually a company selling the insurance.

Insurance relies on the law of large numbers which states that “when a large number of units are used in
an experiment, the actual experience will closely approximate the underlying theoretical probability or
experience” this law is critical to insurance and is critical for its operations and practicability.

Insurance is a device that:-

(i) Spreads risk over a large number of persons who are exposed to it and are willing to cover
themselves against the risk.

(j) Transfers each member’s individual risk to all the members of the large group.

(k) Enables each member’s individual loss to be borne by all the members of the group.

(d) Allows for each member’s loss to be compensated for by the contributions of all the members.

(e) Ensures that a certain sum called the premium is charged in consideration.

(f) Provides for the payment to depend upon the value of loss due to the particular insured risk provided
insurance is there up to that amount.

The main assumptions in insurance are:-

(1) That a large number of units are exposed to the risk.

(2) That it is possible to accurately predict the number of units that will suffer loss within a specified
period of time.
 (3) That only a few of the units exposed to the risk will actually suffer loss within a specified period
of time.

(4) That the losses of the unfortunate few who suffer losses are compensated for by the contributions
of the fortunate many

CONDITIONS NECESSARY INSURANCE

1. There must be a large number of homogeneous, similar and independent exposure units. The
vast majority of insurance policies are provided for individual members of very large classes. For
insurance to work, a large number of units must have been exposed to the risk in the past over a
period of time. Large numbers make it possible to examine and observe how the risk has caused
losses in the past which then make it possible to statistically estimate expected future losses
accurately. It is pointless to estimate future losses based on large numbers and then insure only
a few units. In such a situation the actual loss experience will not closely approximate the
estimated loss and the insurer will be problems. A large number of units must be insured if the
actual loss experience is to be roughly equal to the estimated loss.

The large number of units must be homogenous. This means that they must be roughly equal in value
and structure. High value units should not be placed in the same group with low value units as the loss of
one high value unit will be equivalent to the loss of many low valued units in the group. The impact will
be the same as if many units have suffered loss within the same specified period of time. This is contrary
to the basic assumption in insurance that only a few of the units exposed to loss will suffer loss within a
specified period of time.

The large number of units must be independent of each other. This means that the loss of any one unit
in the group must not influence the loss of any other unit or units within the same group. If this were to
happen, the loss of one unit will lead to the loss of another unit which will also lead to the loss of another
and another. In the end many of the units will suffer loss within the same period of time.

2. The Loss must be definite in time, place and value. The event that gives rise to the loss
that is subject to insurance should, at least in principle, take place at a known time, in a
known place, and from a known cause. It must also have a known value. Proof that a loss
has occurred is only possible if the place in which the loss occurs, and the time that the loss
occurred can be confirmed beyond any doubt. Without these two, a loss could be an
imaginary loss. Insurers only compensate for confirmed losses. Insurers normally
compensate for the value of the loss suffered. This is normally in financial terms. It should
be possible to quantify or measure the loss in monetary value. It is not possible to value
sentimental losses such as loss of love in financial terms. It would be impossible to
determine how much the insurer should for such losses in monetary value. The insurer only
compensates for losses proximately caused by a peril that is insured in the policy. It must
therefore be possible to determine the proximate cause of the loss. It must be possible to
confirm the cause of the loss. Ideally, the time, place, value and cause of a loss should be
clear enough that a reasonable person, with sufficient information, could objectively verify
all four elements.
 3. The loss must be accidental. The event that causes the loss should be fortuitous, or at least
outside the control of the beneficiary of the insurance. The occurrence of the loss must be
purely a matter of chance and not the deliberate act of the insured. Insurance does not
cover losses intentionally caused in the hope of obtaining financial gain from the insurer.
Events that contain speculative elements, such as ordinary business risks, are generally not
considered insurable.

4. It must be economically feasible. It must make economic sense to insure. For this to
happen, certain things are necessary. First, the potential size of the loss from the risk must
be large enough to cause financial hardship to the insured if it does cause a loss. It is not
economical to insure against a risk whose potential loss is negligible and can be comfortably
be absorbed by the insured without any stress. Secondly, the insurance premiums charged
need to cover both the expected cost of losses, plus the cost of issuing and administering
the policy, adjusting losses, and supplying the capital needed to reasonably ensure that the
insurer will be able to pay claims. It is not economical from the insurer’s point of view to
provide cover where the premium charged is not enough to cover the cost of insurance.
Thirdly, the premium payable must be affordable. It is not economical from the insured’s
point of view if the premium charged is nearly as large as the potential loss from the risk
covered. It is only economical where the premium payable is relatively very small compared
to the size of the expected loss. Finally, the chance of a loss occurring must be reasonably.
It not economical to insure against a risk that has no chance of causing a loss. It may also be
uneconomical to insure against a risk which has an unreasonably very high chance of loss
together with a very large potential loss from the risk. There is no point to insure if the
policy has no financial to both the insurer and the insured to both the insured and the
insurer.

5. There should be no catastrophically large losses or hazard. An insurance scheme cannot

work in a situation where most of the insured units suffer loss within a specified period of
time. If the same event can cause losses to numerous policyholders of the same insurer,
the ability of that insurer to compensate for all the losses will be limited. Or where the loss
from one single event would be extraordinarily large, the insurer’s ability to compensate
for it and other exposures. It is possible to find risks whose total potential loss is well in
excess of any individual insurer’s capital reserves.

6. There must be insurable interest. Insurable interest is essential for the validity of any
contract of insurance. Insurance contracts cannot be enforced in any court of law where
insurable is lacking. It is a necessary requirement for insurability.

BENEFITS OF INSURANCE

(i) Insurance eliminates uncertainty.

Insurance provides certainty of payments at the uncertain of loss. The uncertainty of loss can be reduced
by better planning and administration. But the insurance relieves the person from such difficult tasks.
Moreover if the subject matters are not adequate, the self- provision may prove costlier. There are
different types of uncertainty in a risk. The risk will occur or not, when it will occur, how much loss will be
there? In other words there are uncertainty of happening of time and amount of loss. Insurance removes
all these uncertainty and the assured is given certainty of payment loss. The insurer charge premium for
providing the said uncertainty

(ii) Insurance provides protection.

The main benefit of the insurance is to provide protection against the probable chances of loss. The time
and amount of loss are uncertain and at happening of the risk the person will suffer loss in absence of
insurance. The insurance provides safety and security against the loss on a particular event. In case of life
insurance payment is made when death occurs or when the term of insurance expires. The loss to the
family at a premature death and payment in old age are adequately provided by the insurance. In other
words security against premature death and old age suffering are provided by life insurance. Similarly the
property of the insured is secured against on a fire in fire insurance. In other insurance too, this security
is provided against the loss at a given contingency. The insurance provides safety and security against the
loss of earning at death or in old age against the loss at fire, against the loss at damage, destruction or
disappearance of property, goods, furniture and machines etc.

The insurance guarantees the payment of loss thus it secures and protects the assured from sufferings.
Insurance cannot check the happening of risks but can provide for losses at the happening of the risk.

(iii) Insurance Affords Peace of Mind

The security wish is the motivating factor. This is the wish which tends to stimulate to more work, if wish
is unsatisfied it will create a tension which manifests itself to the individual in the form of an unpleasant
reaction causing reduction in work. The security banishes fear and uncertainty, fire, windstorm,
automobile accident, damage and death are almost beyond the control of the human agency and in
occurrence of any of these events may frustrate or weaken the human mind. By means of insurance,
however, much of the uncertainty that centers about the wish for security and its attainment may be
eliminated.

(iv.) Risk Sharing

The risk is uncertain and therefore the loss arising from the risk is also uncertain. When risk takes place
the loss is shared by all the persons who are exposed to the risk. The risk sharing in ancient times was
done only at time of damage or death but today on the basis of probability of risk the share is obtained
from each and every insured in the shape of premium without which protection is not guaranteed by the
insurer.

(iv.) Prevention of loss

The insurance joins hands with those institution which are in preventing the loses of the society because
reduction in losses causes lesser payment to the assured and so more saving is possible which will assist
in reducing the premium. Lesser premium invites more business and more business cause lesser share to
the assured. So again premium is reduced to which will stimulate more business and more protection to
the masses. Therefore the insurance assists financially to the health organization, fire brigade, educational
institutions, and other organizations which are engaged in preventing the losses of the masses from death
and damage.

(v) It provides capital

The insurance provides capital to the society. The accumulated funds are invested in productive channel.
The dearth of capital of the society is minimized to a greater extent with the help of investment of
insurance. The industry, the business and the individual are benefited by the investments and loans of the
insurers.

(vi) It improves efficiency

The insurance eliminates worries and miseries of losses at death and destruction of property. The carefree
person can devote his body and soul together for better achievement. It improves not only his efficiency
but the efficiency of the masses are also advanced.

(vii) It helps economic progress

The insurance by protecting the society from huge losses of damage, destruction and death, provides an
initiative to work hard for the betterment of the masses. The next factor of economic progress, the capital,
is also immensely provided by the masses. The property, the valuable assets, the man, the machine and
the society cannot lose much at the disaster.

(viii) Insurance Eliminates Dependency

At death of the husband or father the destruction of family need no elaboration. Similarly at destruction
of property and goods the family would suffer a lot. It brings reduced standards of living and suffering
may go to any extent of begging from relatives, neighbors or friends. The economic independence of the
family is reduced or sometimes lost totally. What can be more pitiable condition than this that the wife
and children are looking others more benevolent than the husband and the father in absence of protection
against such dependency? The insurance is here to assist them and provides adequate amount at the time
of sufferings.

(ix) Life Insurance Encourages Saving

The element of protection and investment are present only in case of life insurance. In property insurance,
only protection element exists. In most of the life policies elements of saving predominates. These policies
combine the programs of insurance and savings. The saving with insurance has certain extra advantages:

i. Systematic saving is possible because regular premiums are required to be compulsory paid. The
saving with a bank is voluntary and one can easily omit a month or two and then abandon the
program entirely.

ii. In insurance the deposited amount cannot be withdrawn easily before the expiry of the term of
the policy. As contrast to this the saving which can be withdrawn at any moment will finish with
no time.
 iii. The insurance will pay the policy money irrespective of the premium deposited while incase of
bank deposit only the deposited amount along with interest is paid. The insurance thus provide
the wished amount of insurance and the bank provides only deposited amount.

iv. The compulsion or force to premium in insurance is so high that if the policy holder fails to pay
premiums within the days of grace he subjects his policy to lapse and may get back only a nominal
portion of the total premiums paid on the policy. For the preservation of the policy he has to try
his level best to pay the premium. After a certain period it would a part of necessary expenditure
of the insured. In absence of such forceful compulsions elsewhere life insurance is the best media
of saving.

(x) Life Insurance Provides Profitable Investment

Individuals unwilling or unable to handle their own funds have been pleased to find an outlet for their
investment in life insurance policies. Endowment policies, multipurpose policies differed annuities are
certain better form of investment. The elements of investments i.e. regular savings, capital formation and
return of capital along with certain additional returns are perfectly observed in life insurance. In India the
insurance policies carry a special exemption from income tax, wealth tax, gift tax and estate duty. An
individual from his own capacity cannot invest regularly with enough of security and profitability. The
insurance fulfills all these requirements with a lower cost. The beneficiary of the policy holder can get a
regular income from the life insurer, if the insured amount is left with him.

(xi) Life Insurance Fulfils the Needs of a Person

The needs of a person are divided into:

A. Family needs

B. Old age needs

C. Re adjustments needs

D. Special needs

E. The clean up needs

(A) Family needs

Death is certain but the time is uncertain. So there is uncertainty of time when the sufferings and financial
stringencies may befall on the family. Moreover every person is responsible to provide for the family. It
would be amore pathetic sight in the world to see the wife and the children of a man looking for someone
more considerate and more benevolent than the husband and the father who left them unprovided.
Therefore the provision for children up to their reaching earning period and for widow up to long life
should be made. Any other provision except life insurance will not adequately meet this financial
requirement of the family. Whole life policies are the better means of meeting such requirements.
(B) Old Age Needs

The provision for old age is required where the person is surviving more than his earning period. The
reduction of income in old age is serious to the person and his family. If no any other family member starts
earning they will be left with nothing and if there is no property it would be more piteous state. The life
insurance provides old age funds along with the protection of the family by issuing various policies.

(C) Re adjustments Needs

At the time of reduction in income whether by loss of employment, disability or death adjustments in the
standard of living is required. The family members will have to be satisfied with the meager income and
they have to settle to lower incomes and social obligations. Before coming to lower standards and to be
satisfied with that they require, certain adjustments income so that the primary obstacles may be reduced
to minimum. The life insurance helps to accumulate adequate funds. Endowment policy, anticipated
endowment policy and guaranteed triple benefit policies are deemed to be good substitute for old age
needs.

(xii) Special Needs

There are certain special requirements of the family which are fulfilled by earning member of the family.
If the member becomes disabled to earn due to old age or death those needs may remain unfulfilled and
the family will suffer:

(i) Need for Education

There are certain insurance policies and annuities which are useful for education of the children
irrespective of the death or survival of the father or guardian.

(ii) Marriage

The daughter may remain unmarried in case of father’s death or incase of inadequate provision for
meeting the expenses of marriage. The insurance can provide funds for the marriage if policy is taken for
the purpose.

(iii) Insurance Needs for Settlement of Children

After education settlement of children takes time and in absence of adequate funds the children cannot
be well placed and all the education will go to waste.

(E) Clean up Funds

After death ritual ceremonies payment of wealth taxes and income taxes are certain requirements which
decrease the amount of funds of the family member. Insurance comes to help for meeting these
requirements. Multipurpose policy, education and marriage policies, capital redemption policies are the
better policies for the special needs.

USES TO BUSINESS
The insurance has been useful to the business society also. Some of the uses are discussed below:

1. Uncertainty of business Losses is Reduced

In world of business, commerce and industry a huge number of properties are employed. With a slight
slackness or negligence the property may be turned into ashes. The accident may be fatal not only to the
individual or property but the third party also. New construction and new establishments are possible
only with the help of insurance. In absence of it uncertainty will be to the maximum level and nobody
would like to invest a huge amount in the business or industry. A person may not be sure of his life and
health and cannot continue the business up to longer period to support his dependants. By purchasing
policy he can be sure of his earnings because the insurer will pay a fixed amount at the time of death.
Again the owner of the business might foresee contingencies that would bring great loss. To meet such
situation they might decide to set aside annually a reserve but it not be accumulated due to death.
However by making an annual payment to secure immediately insurance policy can be taken.

2. Business efficiency is Increased with Insurance

When the owner of a business is free from the botheration of losses he will certainly devote much time
to business. The carefree owner can work better for maximization of profit. The new as well as the old
businessmen are guaranteed payment of certain amount with insurance policies at death of the person,
at damage, at destruction or disappearance of the property or goods. The uncertainty of the loss may
affect the mind of the businessmen adversely. The insurance removing the uncertainty stimulates the
businessmen to work hard.

3. Key Man Indemnification

Key man is that particular man whose capital, expertise, experience, energy, ability to control goodwill
and dutifulness makes him the most valuable asset in the business and whose absence will reduce the
income of the employer tremendously and up to that time when such employee is not substituted. The
death or disability of such valuable lives will in many instances prove a more serious loss than that of fire
or any hazard. The potential loss to be suffered and the compensation to the dependents of such
employee require an adequate provision which is met by purchasing an adequate life policy. The amount
of loss may be up to the amount of reduced profit, expenses involved in appointing and training of such
persons and payment to the dependents of the key man. The term Insurance Policy or Convertible term
Insurance Policy is more suitable in this case.

4. Enhancement of Credit

The business can obtain loan by pledging the policy as the collateral for the loan. The insured persons are
getting more loan due to certainty of payment at their deaths. The amount of loan that can be obtained
with such pledging of policy with interest thereon will not exceed the cash value of the policy. In case of
death the cash value can be utilized for settling of the loan along with the interest. If the borrower is
unwilling to repay the loan and the interest the lender can surrender the policy and get the amount of
loan and interest thereon repaid. The redeemable debentures can be issued on the collateral of capital
redemption policies. The insurance properties are the best collateral and adequate loans are granted by
lenders.
5. Business Continuation

In any business particularly partnership business may discontinue at death of any partner although the
surviving partners can restart the business, but in the cases the business and the partners will suffer
economically. The insurance policies provide adequate funds at the time of death. Each partner may be
insured for the amount of his interest in the partnership and his dependents may get that amount at the
death of the partner.

With the help of property insurance the property of the business is protested against disasters and the
chance of closure of the business due to tremendous waste or loss.

6. Welfare of Employees

The welfare of the employees is the responsibility of the employer. The former are working for the latter.
Therefore the latter has to look after the welfare of the former which can be provisions for early death,
provisions for disability and provisions for old age. These requirement are easily met by the life insurance,
accident and sickness benefit, and pensions which are usually provided by group insurance. The premium
for group insurance is generally paid by the employer. This plan is the cheapest form of insurance for the
employers to fulfill their responsibilities. The employees will devote their maximum capacities to
complete their jobs when they are assured of the above benefits. The struggle and the strife between the
employers and employees can be minimized easily with the help of such schemes.

USES TO THE SOCIETY

Some of the uses of insurance to the society are discussed in the following sections:

1. Wealth of the Society is Protected.

The loss of a particular wealth is protected with insurance. Life insurance provides loss of human wealth.
The human material if it strong, educated and carefree will generate more income. Similarly the loss of
damage of property at fire, accident etc, can be well indemnified by the property insurance; cattle, crop,
profit and machines are also protected against their accidental and economic losses. With the
advancement of the society, the wealth of the property of the society attracts more hazardous and so
new types of insurances are also invented to protect them against the possible losses. Each and every
member will have financial security against old age, death, damage, destruction and disappearance of his
wealth including the life wealth. Through prevention of economic losses, insurance protects the society
against degradation. Through stabilization and expansion of business and industry, the economic security
is maximized. The present, future and potential human and property resources are well protected. The
children are getting expertise education, working classes are free from botherations and other people are
guiding at ease. The happiness and prosperity observed everywhere with the help of insurance.

2. Economic Growth of the Country

For the economic growth of the country insurance provides strong hand and mind, protection against loss
of property and adequate capital to produce more wealth. The agriculture will experience protection
against losses of cattle, machines, boilers and profit insurances provide confidence to start and operate
the industry. Welfare of employees create a conducive atmosphere to work: adequate capital from
insurers accelerate the production cycle. Similarly in business too the property and human materials are
protected against certain losses, capital and credit are expanded with the help of insurance. Thus the
insurance meets all the requirements of the economic growth of a country.

3. Reduction in Inflation

The insurance reduces the inflationary pressure in two ways: first, by extracting money in supply to the
amount of premium collected and secondly by providing sufficient funds for production narrow down the
inflationary gap. With reference to Indian context it has been observed that about 5.0 percent of the
money in supply was collected inform of premium. The share of premium contributed to the total
investment of the country was about 10.0 per cent. The two main causes of inflation, namely increased
money in supply and decreased production are properly controlled by insurance business.

3. Insurance Protects Mortgaged Property

At death of the owner of the mortgaged property the property is taken over by the lender of the money
and the family will be deprived of the uses of the property. On the other hand the mortgagee wishes to
get the property insured because at the damage or destruction of the property he will loose his right get
the loan repaid. The insurance will provide adequate amount to the dependants at the early death of the
property owner to pay off the unpaid loans. Similarly the mortgagee gets adequate amount at the
destruction of the property.
TOPIC TWO: PRINCIPLES OF INSURANCE

The principles will act as a guideline both to person(s) who may want to persuade an insurance company
to bear on his or their own behalf the loss that may be incurred by a given risk and to the insurance
company that would as a result undertake the cover. The following is an outline of these principles:

1. INSURABLE INTEREST

A contract of insurance affected without insurable interest is void. It means that the insured must have
an actual pecuniary interest and not a mere anxiety or sentimental interest in the subject matter of
insurance. The insured must be so situated with regard to the thing insured that he would have benefit
by its existence and loss from its destruction. The owner of a ship rubs a risk of losing his ship, the chatterer
of the ship runs a risk of losing his freight and the owner of the cargo incurs the risk of losing his goods
and profit. It is the existence of insurable interest in a contract of insurance, which distinguishes it from
mere watering equipment.

In relation to insurance the law the principle of insurable interest prevents people taking out an insurable
contract on someone else’s life (or someone else’s property) unless they have an insurable interest in that
life.

Valid forms of insurable interest include being a spouse being financially dependent on the person or
situations where there is joint ownership of real property or a business.

The concept of insurable interest was established to prevent:

 Gambling (on the lives of others), under the pretense of insurance.

 The moral hazard of the people taking out insurance on someone’s life, and then “arranging” for
that person to die- so that they can claim on the policy.

WAYS IN WHICH INSURABLE INTEREST CAN ARISE

a) One’s own life;

Life is the most valuable possession one could have. It’s priceless and therefore its value can’t be
quantified in monetary terms. There is therefore no financial limit to the insurable interest that a person
has in his life.

b) Husband-wife relationship; Spouses have insurable interest in each other’s life. This arises out of
biblical and common law concept that a man and his wife are one and the same person. Since their lives
belong to each other, this gives them insurable interest in each other’s life.

c) Creditor-debtor relationship; The creditor stands to suffer financial loss if the debtor dies before paying
the debt. This gives the creditor some insurable interest in the life of the debtor. The insurable interest is
limited to the total debt outstanding. He can therefore insure the debtor’s life on any sum that does not
exceed the debt outstanding. The debtor on the other hand cannot suffer any financial loss if the creditor
dies. He therefore has no insurable interest in the life of the creditor.
d) Partnership relationship; Business partners have insurable interest in each other’s life. This is because
the business stands to suffer financial loss if one partner(s) dies. This is as a result of withdrawal of capital
from the partnership to the dead partner’s estate. The surviving partners would therefore have financial
stress. This gives them insurable interest in each other’s life. The insurable interest is limited to each
partner’s financial involvement with the partnership.

e) Ownership; A person who is not the legal owner of a property stands to suffer financial if the property
is lost or damaged or incurs any liability. The extent of the loss would be limited to the financial value of
the property itself or the resulting liability. This gives the property owner insurable interest in the property
owned. He can insure such property for any sum not exceeding its market or financial value.

f) Joint ownership; A partner has insurable interest in any property jointly with another or others. The
insurable interest is limited to the full financial value of the property jointly owned at its full values, but
he will be insuring on his own behalf and on the behalf of the other owner(s). it follows then that the
compensation will be made to all the owners if a loss occurs.

g) Bailee; A bailee is a person who is legally in possession of property or goods belonging to another
person. He is required by law to take care of the goods in his custody as if they were his own. He can be
held liable for any goods lost, damaged or which incurs liability while in his custody. This gives him
insurable interest in the goods in his custody. He can insure such goods for a sum not exceeding their
market value or financial liability that could arise.

h) Administrators, trustees and executors; These are people charged with the responsibility of taking
care of the estates of others. They have a legal duty to take care of the estates under their charge as if
they were their own. This gives them insurable interest in any property belonging to the estate. They can
insure such property at their full market or financial value, not on their own behalf but on the behalf of
the estate.

i) Potential liability; A person has insurable interest in any potential liability that could cause him or her
financial loss. He can insure for a sum that does not exceed the full financial extent of the potential liability.

2. INDEMNITY

A contract of insurance where the insurable interest is limited and can be valued in financial terms is a
contract of indemnity. The object of every contract of insurance is to place the insured in the same
financial position as nearly as possible after the loss as if the loss had not taken place at all. This means
then that the insured in case of loss against which the policy has been insured shall be paid the actual
amount of loss he has suffered as a result of the operation of the insured risk but not exceeding the
amount of the sum insured in the policy. Indemnity therefore simply means what the insured has actually
lost is what he or she gets nothing more nothing less. It is exact financial compensation for a loss suffered
through a particular risk. Why is it not advisable to allow the insured to obtain from the insurer a value
that is greater than what he or she has actually lost? If the insured could end up with more money than
he has actually lost he would have made a profit out of the occurrence of the risk. This would constitute
a serious moral hazard as people would be tempted to deliberately cause their own loss in order to get
this profit. More losses would occur as more people strive to make profits from their insurance contracts.
The claims would overwhelm the insurers who will find it impossible to compensate every one. It is
therefore against the public policy to allow an insured to make a profit out of his loss or damage.

The principle of indemnity does not apply to life assurance contracts and personal accident insurances
where the insurable interest is unlimited and cannot be valued in monetary terms. It will however apply
to life assurance contracts where the insurable interest is limited and can be valued financially such in the
case of a creditor insuring the life of his debtor.

METHODS OF PROVIDING

i) Cash payments;

When the insurer pays for the cash value of the item lost or the cash value of the assessed reduction in
the value of an item as a result of the occurrence of the insured peril. This is the most common method
of providing indemnity.

ii) Replacement;

In this case the insurer replaces the items lost by providing the insured with another item of similar
financial value. This method is mostly used where the items was still brand new or doesn’t depreciate in
value over a period of time. For example; jewelry like gold ring, diamond etc.

iii) Repairs;

This method is mostly used in motor vehicle insurance where the insurer arranges for the damaged vehicle
to be repaired and pays for the cost of repairs with the garage concerned. Adequate repairs constitute
indemnity.

iv) Re-instatement;

this method is mostly used in fire insurance policies. The insurer rebuilds the premises which have been
damaged by fire. In ordinary circumstances the insurer prefers to pay cash to the insured for the damaged
premises so that the insured himself will undertake the building. This is because the insurer would not like
to be involved with the disagreement which will arise between him and the insured when he undertakes
to rebuild himself. The disagreement usually relate to either the quality of the materials used in the
rebuilding or the standard of the workmanship involved. However where the insurer suspects the fire was
caused by arson but have no adequate proof he may opt that instead of providing cash for rebuilding he
will undertake the rebuilding himself. This is because the insured may have caused the fire for the
purposes of obtaining money from the insurer and the insurer is allowed by law to insist on rebuilding
rather providing the cash.

CIRCUMSTANCES THAT HINDER FULL INDEMNITY

In practice it is sometimes possible that a person who has suffered financial loss as a result of an insured
peril may not be taken to the same financial position he was in immediately before the loss occurred. The
following circumstances may operate to prevent the insured from obtaining full indemnity.
i) Sum insured

The maximum liability of the insurer in a contract of insurance is the sum insured. There is no obligation
on the part of the insurer to pay for sum which exceeds the sum insured. Therefore in a situation where
the insured, insured his property for a sum which is less than the market value or the financial value of
the property insured he may not be fully indemnified when a loss occurs as the insurer will only pay the
sum insured which will be less than the financial value of the loss.

ii) Where the insurance policy is subject to average;

Where the property is insured on the understanding that the sum insured is the financial value of the
property insured, the policy will become subject to average if it turns out that the property was actually
more than the sum insured. It will be understood that in such circumstances the insured did not transfer
the whole risk to the insurance company. The insured therefore retains part of the risk and if the loss
occurs the insurer will only compensate for the proportion of the loss that was transferred to him. They
therefore share the loss with the insured person.

iii) Policy Excess;

This is a statement or a clause in motor vehicle insurance policy which states that; if a loss occurs and the
insured want to make a claim for compensation he will pay a specified sum of money to the insurer before
his claim can be processed and paid. This clause serves to prevent the insured from launching what is
called petty or trivial claims. It results in less than the indemnity being paid.

iv) Policy Franchise;

A franchise policy is similar to the policy excess in that they serve the same purpose of eliminating trivial
or petty claims. The difference is only that in a franchise there is a clause stating that the insurer will only
compensate for a loss if total value exceeds a specified sum of money. Compensation can only be paid
where the value of the loss is greater than the franchise amount.

3 CONTRIBUTION

Contribution is the right of an insurer to call upon other insurers who have insured the same risk to share
in the cost of an indemnity payment. Where there are two or more insurers on one risk, the principle of
contribution comes into play. The aim of contribution is to prevent the insured from making a profit by
claiming in full from all insurers against the same loss. It achieves this by distributing the actual amount
of loss among the different insurers who are liable for the same risk under different policies in respect of
the same subject matter. Any one insurer may pay to the insured the full amount of the loss covered by
the policy and then become entitled to contribution from his co-insurers in proportion to the amount
which each has undertaken to pay in case of the same subject matter.

The following conditions are necessary for contribution to apply.

(i) There must be at least two or more policies of indemnity existing.

(ii) The two or more policies of indemnity must cover the same peril or risk.

(iii) The two or more polices of indemnity must cover the same subject matter of
insurance.

(iv) They must cover the same interest of the same insured.

(v) They must be in force at the time of loss.

METHODS OF CALCULATING CONTRIBUTIONS

There are two methods that can be used in calculating contribution. These include:

a) Sums insured method;

This method is used where the total of all the sums insured is either equal to or greater than the financial
value of the insured property. It applies where the whole risk is transferred to the insurers and they
therefore share in contributing for the whole loss. The formula for calculating the contribution is:

sum insured by individual insurer X Loss sustained

Total of loss insured

b) Independent liability method;

This method is normally used when a policy is subject to average. This means that the whole risk was not
transferred to the insurer. The insured retained part of the risk. It is therefore applied where the total of
all sums insured by the different insurers is less than the market value of the subject matter insured. The
formula used is;

Sum insured by individual insurer X Loss sustained

Market or financial value of the property insured

In conclusion the principle of the contribution only applies to contracts of indemnity where the insurable
interest can be valued in monetary terms.

4 SUBROGATION
In insurance subrogation is the right of an insurer to stand in the place of the insured and to avail to
himself all the rights and remedies available to the insured, whether such rights have been exercised or
not. It is a corollary to the principle of indemnity and applies only to contracts of indemnity. It operates
to prevent the insured from making a profit out of a contract of insurance by claiming twice. Where the
insured property is lost or damaged through the negligence of say a third party, the insured can make a
profit by claiming in full from both his insurer and the third party. This would be contrary to the
requirements of the principle of indemnity which prohibits parties from making profits out of contracts
of insurance. Subrogation only applies to contracts of indemnity where the insurable interest is limited
and can be valued financially. It does not apply to those life assurance contracts and personal accident
insurances where the insurable interest is unlimited and cannot be valued in monetary terms.
Subrogation requires that when an insured has received full indemnity in respect of his loss, all rights
and remedies which he has against any third person will pass on to the insurer and will be exercised for
his benefit until he (the insurer) recoups the amount he has paid for the loss for which he is liable under
the policy and this right extend only to the rights and remedies available to the insured in respect of the
thing to which the contract of the insurance relates.

Subrogation is the same name given to the legal technique under the common law by which one party
(P) steps into the shoes of another party (X), so as to have the benefit X’s rights and remedies against
the third party (D). subrogation is similar in effect to assignment, but unlike assignment subrogation can
occur with any agreement between P and X to transfer X’s rights. Subrogation most commonly arise in
relation to policies of insurance but the legal technique is more of general application. Using the
designations above, P (the party seeking to enforce the rights of another) is called subrogee. X (the party
whose rights the subrogee is enforcing) is called the subrogor.

In each case because P pays money to X which otherwise D would have had to pay, the law permits P to
enforce X’s rights against D to recover some or all of what P has paid out. A very simple (and common)
example of subrogation would be as follows:

1. D drives a car negligently and damages X’s car as a result.

2. X, the insured party has comprehensive insurance and claims (ie asks for payment) under the
policy against P, his insurer.

3. P pays in full to have X’s car repaired.

4. P then sues D for negligence to recoup some or all of the sums paid out to X.

5. P receives the full amount of any amounts recovered in the action against D up to the amount to
which P indemnified X. X retains non of the proceeds of the action against D except to the
extent that they exceed the amount P paid to X.

If X were paid in full by P and still claim in full against D then P could recover “twice” for the same loss.
The basis of the law of subrogation is that when P agrees to indemnify X against a certain loss, then X
“shall be fully indemnified, but never more than fully indemnified …if ever a proposition was brought
forward which is at variance with it, that is to say, which will prevent X from obtaining a full indemnity,
or which will give to X more than full indemnity, that proposition must certainly be wrong.” P will
normally (but not always) have to bring the claim in the name of X. accordingly, in situations where
subrogation rights are likely to arise within the scope of a contract (i.e. in an indemnity insurance policy)
it is quite common for the contract to provide for that X as subrogor will provide all necessary
cooperation to P in bringing the claim.

Subrogation is an equitable remedy and is subject to all the usual limitations which apply to equitable
remedies.

Although the basic concept is relatively straightforward subrogation is considered to be a highly

technical area of the law.

Types of subrogation

Although the classes of subrogation rights are not fixed (or closed) types of subrogation are normally
divided into the following categories:

i. Indemnify insurer’s subrogation rights

ii. Surety’s subrogation rights

iii. Subrogation rights of business creditors

iv. Lender’s subrogation rights

v. Banker’s subrogation rights

Although the various fields have the same conceptual underpinnings there are subtle distinctions
between them in relation to the application of the law of subrogation.

i) Indemnify insurer’s subrogation rights

An indemnity insurer in fact has two distinct types of subrogation rights. Firstly they have the classic
type of subrogation used in the example above; viz. the insurer is entitled to take over the remedies of
the insured against another party in order to recover the sums paid out by the insurer to the insured
and by which the insured would otherwise be overcompensated. Secondly the insurer is entitled to
recover from the insured and by which the insured is overcompensated. The latter situation might arise
if, for example an insured claimed in full under the policy but then started proceeding anyhow against
the tortfeasor, and recovered substantial damages.

ii) Surety’s subrogation rights

A surety who pays off the debts of another party is subrogated to the creditor’s former claims and
remedies against the debtor to recover the sum paid. This would include the endorser on a bill of
exchange.

In relation to surety’s subrogation rights, the surety will also have the benefit of any security interest in
favor of the creditor of the original debt. Conceptually this is an important point, as the subrogee will
take the subrogor’s security rights by operation of law, even if the subrogee had been unaware of them.
Accordingly in this area of the law at least, it is conceptually improbably that the right of subrogation is
based upon any implied on them.

iii) Subrogation rights against trustees

A trustee or a trust that enters into a transaction for the benefit of the beneficiaries of the trust is
generally entitled to be indemnified by the beneficiaries for personal loss incurred, and has lien over the
trust assets to secure compensation. If for example the trustee conducts business on behalf of the trust
and fails to pay creditors then the creditors are entitled to subrogate to the personal and proprietary
remedies of the trustee against the beneficiaries and the trust fund. Where under the terms of the trust
instrument the trustees are permitted to trade in derivatives as part of the trust’s investment strategy,
then the derivatives document will also normally contain a subrogation clause to bolster the common
law rights.

iv) Lender’s subrogation rights

Where the lender lends money to a borrower to discharge the borrower’s debt to a third party (or which
the lender pays directly to the third party’s to discharge debt), the lender is subrogated to the third
party’s former remedies against the borrower to the extent of the debt discharged.

However if the original loan was invalid (because for example it is ultra vires the borrower) then the
lender generally cannot enforce the third party’s claim against the borrower as this would indirectly
validate an invalid loan. However the claim can subsist in so far as the unlawfully borrower money was
used to discharge lawful debts, by inferring the legality of the use of funds to the right of subrogation.
However the law in this area has been subject to conflicting decisions.

v) Banker’s subrogation rights

Where a bank acting on what it believes erroneously to be valid mandate of its client, pays money to a
third party which discharges the customer’s liability to the third party, the bank is subrogated to the
third party’s former remedies against the customer.
5 UTMOST GOOD FAITH

Since insurance shifts risk from one party to another, it is essential that there must be utmost good faith
and mutual confidence between the insured and the insurer. In a contract of insurance the insured
knows more about the subject matter of the contract than the insurer. Consequently he is duty bound
to disclose accurately all materials facts and nothing should be withheld or concealed. Any fact is
material which goes to the root of the contract of insurance and has a bearing on the risk involved. It is
only when the insurer knows the whole truth that he is in a position to judge if he should accept the risk
and what premium he should charge.

If that were so the insured might be tempted to bring about the event insured against in order to get the
money. Generally the rule applicable to contracts of insurance is that of uberrime fides, which means
“of the utmost good faith” utmost good faith is therefore a rule that require that each party in the
contract of insurance is under the legal obligation to disclose all material facts affecting the contract,
whether such facts have been specifically requested for or not. A material fact is any fact which would
influence the judgment of a prudent insurer in deciding if to accept to insure or not, or in determining
the amount of premium to be charged. Examples of material facts include:

b) The fact that a life proposed for insurance has been hospitalized for several times before or
suffers from known serious infection is regarded as a material fact.

c) In motor insurance the fact that the motor vehicle that is proposed for insurance will be driven
on a regular basis by someone else rather than the insured driver is regarded as a material fact

Examples of non-material facts include:

a) Facts which the proposer does not know and which he cannot reasonably be expected to know.
In determining this, the level of education, the professional qualification and the experience of
the proposer will be taken into account.

b) Facts of law: Everyone is presumed to know the law and ignorance of the law is no defense. The
insurer is therefore expected to be aware of all legal provisions affecting the insurance
operations.

6 PROXIMATE CAUSE
The rule of proximate cause means that the cause of the loss must be proximate or immediate and not
remote. If the proximate cause of the loss is a peril insured against, the insured can recover. When a loss
has been brought about by two or more causes, the question arises as to which is the proximate cause,
although the result could not have happened without the remote cause. But if the loss is brought about
by any cause attributed to the misconduct of the insured, the insurer is not liable.

Proximate cause

The legal definition of ‘proximate cause’ is contained with the case Pawsey v Scottish Union & National
(1908):

“Proximate cause means the active, efficient motion that sets in motion a train of events, which brings
about a result, without the intervention of any force started and working actively from a new and
independent source”

Proximate cause is the dominant cause-it does not have to be first.

Life itself is full of events, sometimes occurring independently of each other or as a result of another.
The principle, proximate cause identifies for insurance purposes, which event is the probable cause of a
particular event, leading to a loss and whether this event is insured.

Usually, the first and last event can be easily identified but it is any intermediate events and causes,
which happen, that may be trickier to determine.

The event chain must be carefully considered at each stage, questions as to whether that particular
chain was broken by a new and intervening cause, using logic.

Remote causes

These are when an original event has occurred and started the motion towards loss, when another new
and independent cause occurs and the loss happens. Usually a period of time elapses between the
original causes of the remote cause.

Perils Relevant to Proximate Cause

There are three types of relevant perils, which are as follows:

i) Insured Perils

Those which are stated in the policy as insured, such as fire and lighting

ii) Exempted or Excluded perils

Those stated in the policy as excluded either as causes of insured perils, such as riot or earthquake or as
a result of insured perils

iii) Uninsured or Other Perils

Those not mentioned in the policy at all. Storm, smoke and water are not excluded nor mentioned as
insured in a fire policy. It is possible for water damage claim to be covered under fire policy, if for
example a fire occurs and the fire brigade extinguishes it with water.

iv) Indirect Causes

Some policies sometimes exclude a peril if it caused directly or indirectly by another one.

v) Concurrent Causes

These are losses whereby it is clear that more than one event has occurred at the same time,
contributing to the loss. If there is no expected peril involved and the causes cannot be identified or the
parts of the loss separated, then all the damage will be insured. If the losses can be filtered, then the
appropriate settlements will be made, if insured. If an expected peril is involved in loss involving
concurrent causes and the damage cannot be separated then none of the loss is insured. If it can then
only the insured part of the damaged is insured.

TOPIC THREE

TYPES OF INSURANCE POLICIES

INTRODUCTION

Insurance is a concept, a technique, and an economic institution. It is a major tool of risk management,
and plays an important role in the economic, social, and political life of all countries

LIFE INSURANCE

There are two basic types of life insurance:

a). Term Life Insurance covers you for a period of time or term that you choose.

b). Permanent Life Insurance offers a few more variations, and provides a lifetime of coverage. Each has
benefits that may be important to you depending on the needs in your life

1. Permanent life insurance

Permanent insurance, including Whole Life Insurance, Universal Life Insurance and Variable Universal
Life Insurance, can provide protection for your entire lifetime, or in certain instances up to a specific age
at which point the insurer pays the policy owner the cash value. Permanent life insurance policies can
build cash value money that you can borrow against and in some instances, withdraw to help meet
future goals, such as paying for a child's college education.

Permanent life insurance is for people who:

 May need life insurance for a long term.

 May be interested in accumulating policy cash value to provide funds for education, retirement
or other future goals.

 Want to take advantage of the tax-favored treatment of cash value life insurance policies.
Benefits:

 Over time, permanent insurance may be more economical than term insurance since premiums
do not increase with age and the policy can build cash value.

 Policy loans and withdrawals provide access to your cash value.

 If you cancel the policy, the accumulated cash value, minus any surrender charges, is yours to
use as you wish.

Things You Should Consider:

 Permanent insurance is initially more expensive than term insurance.

 Loans, including any unpaid loan interest, and cash-value withdrawals generally reduce the death
benefit, which could leave beneficiaries inadequately protected.

Whole life

Whole Life is the most basic type of permanent life insurance. Depending on your age and health, your
premium will purchase a specific death benefit and produce a specific cash value, which are guaranteed
for the life of the policy as long as your premiums are paid. Whole Life premiums, while higher than
term premiums, are guaranteed not to increase. In addition, Whole Life policies can earn annual
dividends which are based on MetLife’s investment, mortality, and expense experience. Dividends are
not guaranteed. Whole life insurance is suitable for people:

 Have a lifetime need for insurance protection

 Like to know that their premiums will never increase

Benefits:

Over time, whole life insurance may be more economical than term insurance since premiums do not
increase with age and the policy builds cash value.

 Policy loans and withdrawals provide access to your cash value.

 If you cancel the policy, the accumulated cash value is yours to use as you wish. Taxes may apply.

 Dividends can be taken in cash or used to increase the policy's cash value and death benefit. This
means that certain “dividend options” may be used to purchase additional insurance coverage each
year, regardless of your health.

 Premiums are guaranteed not to increase over the life of the policy.

 A minimum death benefit is guaranteed.

 The cash value is guaranteed to grow at a specified, minimum rate. Some Drawbacks to Consider:

 Unlike term insurance, whole life insurance offers no conversion option.

 Loans, withdrawals and any unpaid loan interest generally reduce the death benefit, which could
leave beneficiaries inadequately protected.

Variable universal life insurance

VUL is a variable universal life insurance policy offers a choice of death benefit guarantees and
investment opportunities. It provides money for your family or other beneficiaries if you die, and money
for you while you're living. Equity Advantage VUL gives you the choice of allocating your net premiums
to one or more of our 50 funding options, including a Fixed Account. Since the policy's cash value will
vary with the performance of the particular funding option(s) chosen, there are no cash value
guarantees. However, there is a greater potential for growth. The more conservative Fixed Account does
provide cash value guarantees. This product is currently available in all states. Variable insurance policy
is for people who:

 Have a need for Life Insurance.

 Have longer time frames to weather the market.

 Want control over where their net premium dollars are allocated.

Benefits:
 There is no set schedule for premium payments after the first policy year, so as your needs and goals
change you may be able to increase, decrease or stop premium payments.

 Since the amount of coverage (face amount) can generally be adjusted, you may never need to
purchase another life insurance policy.

 A minimum death benefit is guaranteed regardless of funding option performance if you maintain
Guaranteed Minimum Death Benefit premium payments at specified levels.

 The potential for your cash value to accumulate more rapidly.

 The flexibility to change the funding options in which your net premiums are invested at any time.

 The ability to transfer money among the funding options at any time, currently without charge.

2. Term Life Insurance

Term insurance is generally the least expensive and least complicated type of life insurance. It provides
insurance protection for a specified period of time, such as 1, 10, 20 or 30 years.' If you die within the
term period and the policy is in force, a death benefit is paid to your beneficiary. If you are still living at
the end of the term, protection ceases unless the policy is renewed. There is no “accumulation”
element, or cash value with term insurance.

Who’s it for?

 People with a temporary need for life insurance protection.

 Those who need a large amount of insurance protection but have limited budgets.

 People with specific business needs (e.g., business owners who want to cover the life of a key
employee who has a set number of years until retirement).

Benefits:

 It provides insurance protection for a low cost (at least initially).

 If your needs change, most term policies allow you to convert to a permanent life insurance policy
without having to take a medical exam or provide other information about your health.

 Term insurance is a good way to supplement other coverage when you have added financial
responsibilities for a given period of time (e.g., mortgage, college expenses.

Things to be considered:

Premiums generally increase with age and they could become unaffordable later in life.

There is no cash-value element, so you miss the tax-deferred growth of the cash value of permanent life
insurance policies, such as Whole Life Insurance. Term Life Insurance. Once the term period expires,
unless you renew your policy, the insurance Coverage ceases and the policy has no further value.

B. HEALTH INSURANCE
Health insurance is a type of insurance whereby the insurer pays the medical costs of the insured if the
insured becomes sick due to covered causes, or due to accidents. The insurer may be a private
organization or a government agency

A Health insurance policy is an annually renewable contract between an insurance company and an
individual. With health insurance claims, the individual policy-holder pays a deductible plus co-payment
(for instance, a hospital stay might require the first Ksh 5000 of fees to be paid by the policyholder plus
500 per night stayed in hospital). Usually there is a maximum out-of-pocket payment for any single year,
and there can be a lifetime maximum.

Prescription drug plans are a form of insurance offered through many employer benefit plans in Kenya
where the patient pays a co-payment and the prescription drug insurance pays the rest.

Some health care providers will agree to bill the insurance company if patients are willing to sign an
agreement that they will be responsible for the amount that the insurance company doesn’t pay, as the
insurance company pays according to “reasonable” or “customary” charges, which may be less than the
provider's usual fee. The “reasonable” and “customary” charges can vary.

Health insurance companies also often have a network of providers who agree to accept the reasonable
and customary fee and waive the remainder. It will generally cost the patient less to use an in-network
provider. An example of an insurance company which offers this type of insurance is Madison Insurance
Company

Madison health insurance policy offers the following benefits:

A. Outpatient benefits —these include

a). Consultation with a general practioner

b). Consultation with a specialist upon referral by a general practitioner

c). Laboratory investigations, x-rays and CT scans

d). Outpatient procedures e.g. dressings, suturing e.t.c

e). Prescribed medicines

B. In patient benefits includes:

a). Admission with a general practitioner

b). Doctor's fees

c). Outpatient procedures e.g. dressings, suturing e.t.c

d). Prescribed medicines

e). Theatre including surgeon's and anesthetists fees

f). Intensive care unit

Madison insurance company may also undertake the following comprehensive covers if called upon to
do so:
Maternity cover—this is normally available to cover pre-natal care, delivery including caesarian and
post-natal care

Dental Cover, optical cover and Dental cover .All these covers are offered at a small premium of 35%

All above Madison insurance company also offers extra benefits to its clients at no extra cost.

These benefits are:

- Road ambulance-in case of emergency

- Air ambulance in case of emergency

- Treatment abroad for a period of up to 45 days when either on holiday or business

- Overseas evacuation, subject to the annual limits selected, for conditions whose treatment is certified
as not locally available

TOPIC FOUR

UNDERWRITING
This is the selection and rating of risks, which are offered to an insurer, hi essence, the task of the
underwriter is to manage the pool (created through insurance) as effectively and profitably as he can.
Thus the roles of an underwriter may be said to be:

• To assess the risk which people bring to the pool.

• Decide whether to accept or not to accept the risk, or how much of the risk, to accept.

• Determine the terms, conditions and scope of cover to be offered.

• Calculate a suitable premium base.

Equally, an underwriter has the task of assessing the hazards associated with the various perils-brought
to the common pool. The concern here is to look out for those hazards that may or might alter the
frequency or severity of the peril. There are two aspects of the hazard, physical and moral which the
underwriter is concerned with.

6.8.1. Physical hazard

These are physical features, which render the proposed risk to be good/bad from, the insurance point of
view. The hazard arises from the natural qualities of the subject matter, in relation to the likelihood and
extent of claims as illustrated below:

• Marine Insurance - type of power used to propel the vessel, type of good comprising the cargo,
geographical area and season involved for the voyage.

• Life Assurance - the health of the proposed assured, the family medical history, the age of proposer.

• Fire Insurance - the construction of the premises, the proximity of the fire brigades, trade processes
involved in the insured premises.

• Accident Insurance - the occupation of the insured (personal accident), the type of machinery used
(employers liability), the system of check and supervision (fidelity guarantee).

Underwriting remedies for bad physical hazard

a) General

Where bad physical hazards exists, which is usually evident at the time the insurance is proposed, the
underwriter can often make suitable adjustments to compensate for the adverse features present.
Where suitable underwriting measures will not counteract the adverse features, then the only prudent
option is to decline the risk altogether.

b) Extra Premium

A suitable increase of premium is made to reflect the hazardousness of the risk.

c) Excess or franchise

A limit Is set for each and every claim such that the first portion of each and every claim made shall be
borne by the insured, say 10%.
d) Reduction of cover

This is done by reducing the cover from say full cover to partial or comprehensive to third party only for
motor insurance.

e) Physical improvements

Conditions are set for improvements to be carried out before a risk is accepted e.g. grills on windows,
steel doors, fencing .. .etc,

f) Suitable policy exclusions

Policy limits coverage through exclusions.

Moral Hazard

This is a risk arising from the nature and behaviour of human beings connected with the subject matter
of the insurance.

Adverse moral hazards and their remedies include:

• Fraud - go off cover

• Carelessness - apply excess or franchise.

• Unreasonableness - refusal at renewal.

• Trend of adverse events - adjust premium upwards or decline renewal.

• Regular claimant - adjust premium upwards.

Underwriting Process

The underwriting process varies from one class of insurance to another and there are usually a variety of
sources of underwriting information, namely:

 The proposer/applicant - the applicant gives both written and oral information before entering
into the contract. The written information is captured in a proposal form.

• » Agents - they provide insurers or underwriters with reports, opinions and recommendations
about the policyholder.

 The insurers own inspection or claims department - insurers maintain their own assessors and
surveyors to provide underwriters with physical inspection reports on the properties of
applicants. Claims department gives up to date statistics of claims experience to help in
renewals.

• Insurers bureaus/associations - these provide rating services or lists of undesirable insurance

applicants. The associations are used to standardise or formulate industry rates and
underwriting factors.

• Other external agencies - automobile agencies, doctors' medical reports and disaster monitoring
bodies are used to provide valuable information at their disposal to underwriters.
Both of the above sources give primary and secondary information to support an underwriter's decision
of taking or refusing the risk. A look of the underwriting process in the following classes of insurance will
help to identify which source(s) is/are applicable.

• Personal Insurance

The main source is the proposal form, which is filled by the applicant. The underwriting process is
delegated to someone like a broker who has authority to issue policies up to ascertain monetary limit of
the sum insured for underwriting purposes.-This is actually applicable in household insurance where
there is little discrimination among those cases, which are acceptable.

• Life Assurance

Here the risk is assessed only at inception of the contract. Due to the provision of the cover for a long
period underwriting involves looking at medical factors, occupational factors, family health history, age
and individual lifestyle factors. HTV/AIDS threat has occasioned additional investigations and strict
underwriting practices. In order to reach a favourable decision an underwriter may require more
additional information e.g. a report from the proposer's doctor on the proposer's medical history,
specific tests and/or medical examination report from an appointed hospital/laboratory.

• Commercial Insurance

Commercial insurances require complicated and exhaustive information. The size of the risk will
determine the level of complexity of the underwriting process. The underwriter will not only depend on
the information provided in the proposal form by the applicant but will also require services of other
experts such as brokers and surveyors. The broker is able to do site visits and prepare a report on the
relevant aspects of the risk. The documentation though extensive in content forms the basis of
underwriting the risk. Risk surveyors have become indispensable in commercial insurance underwriting.
There are various risk specialists in liability fire, security, engineering .,. etc, who prepare comprehensive
reports on:

• The full description of the risk.

• An assessment of the degree of risk. This assessment includes both physical'and moral hazards
surrounding the property which may have an impact on' the magnitude of the risk e.g. in fire
insurance.

• The estimated maximum loss.

• What procedures in terms of safety and security should be taken to protect the insured against
the risk.

• Adequacy of the sum insured. Adequacy of the limit of indemnity.

Premium Determination

The underwriter has the duty to determine the premiums to be paid for any particular risk
accommodated. The' premium, which an insured pays represent the insured's contribution to the
common pool. Premiums must thus be fair and reflect the degree of hazardness, which the insured
brings to the pool.
The factors considered in premium determination include:

• Expected claim costs,

• Operational expenses e.g. salaries, advertising, commission and other office costs.

• Costs relating to outstanding claims

• Costs relating to catastrophic risks

• Reserves

• Profit returns or margins

• Inflation

• Interest rates

• Exchange rates

• Market competition

Premium calculations

Premiums are calculated by applying a premium rate percentage or per rnille to a premium base. The
premium rate captures the hazard and the premium base measures the exposure. Each class of
insurance has different bases upon which premium is determined. In fire insurance a base rate
percentage is applied to the sum insured. In public liability, a rate is applied on turnover while
employers' liability is often rated on the wages paid. Those different bases reflect the Different
exposures and the rates indicate the hazardness level. Premiums calculated may be adjustable or flat
premiums. Insurance companies may charge an adjustable premium e.g. in stock insurance due to its
fluctuating nature while in the majority of cases like motor insurance, a flat premium is charged.

Adjustable premiums

There are certain cases where the exact amount of premium may not be known at the inception of the
policy, in which case an estimate is given. It is this estimated figure that shall be used as a guide to
compute the full premium payable in future. At the end of the policy year the actual figure is worked out
whereupon the initial premium is adjusted either up/down words to reflect the emerging reality. An
example may be in the Employer's Liability cover, where wages may increase/deer ease during the
currency of the cover, besides making adjustments for new recruitments and/or retrenchments,
sackings ...etc, thus, it becomes difficult to provide a precise limit of indemnity at inception of the policy.
In stock insurance for example the actual values of stock vary during the currency of the policy thus
making it difficult to calculate the premium out of the sum insured at 'the beginning of the year. Hence
insured are advised to declare a monthly stock value and pay an estimated premium, which is then
adjusted at the end of the year when the actual value is established.

• Flat Premiums
Hat premiums are those premiums, which are paid at the beginning of the year and require no
adjustments at the end of the year. In most cases the application of a rate to a premium base does not
exist. This is practised in motor insurance, unless the vehicle has a relatively high value to warrant
adjustment. The flat premium is got from the rating tables, which reflect the hazards, associated with
the insured and the vehicle. The underwriting factors to determine the premium are sourced through
the proposal forms.

Life Assurance premiums

Premiums in life assurance incorporate four aspects:

• Mortality - which entails the risk of death as given from the mortality tables?

• Expenses - provides for operating expenses such as administrative, stationery, commissions and
other office costs,

• Investment ~ this takes care of the future income earnings from the invested amounts,

• Contingencies - this provides for the safety margin of unexpected level of losses.
TOPIC FIVE

CLAIMS

Handling claims is the most important aspect of the insurer's advertising. A claim form is the means by
which claims are intimated. The insured may submit his claims personally or through a duly authorised
agent acting on his behalf such as solicitor or an insurance broker. Similarly different persons may act on
behalf of the insurer namely:-

• Insurers' employees - claims department.

• Loss adjusters - professional claim investigators/quantifiers.

• Other agents - solicitors, brokers to agree settlement on their behalf.

Claims Procedure

Claims procedure involves three stages as listed and discussed here after: • Claims notification

• Claims processing

• Claims settlement

 Claims notification

Insurers needs be notified of a claim as soon as possible usually within, a period of 48 hours. This helps
to investigate the claim while evidence is still fresh in the minds of persons involved and witnesses can
be found without difficulties. All events, which may give rise to a claim in due course, must be
communicated to the insurer. This Is necessary since investigations may have to be made to verify the
loss, which may be prejudiced by delay, and chances of recovery from the negligent party are also
reduced if inquiries are not made within a reasonable dispatch. Nearly every insurance policy will
require the policyholder or his legal personal representative to notify the insurer of a possible claim
within the stipulated period. The Limitations Act broadly allows three years for submitting a claim
involving death or injury and six years for other claims. It is important to note that the above procedure
relates to general insurances. In life assurance, the procedure involves the use of courts because the rife
assured may be dead and thus the cause of the claim. It is essential to have the system in force for the
insurer to receive proper proof of death, proper legal identification of the recipient of any proceeds
incorporating any wills and assignments that may have been made.

 Claims processing

This is dealt by the claims department of the insurer. Insurers have to satisfy themselves that:

 Cover was in force at the time of the loss.

  The policy covers the peril.

 The insurer has taken reasonable steps to minimise the loss.

 Conditions have been complied with by the insured.

 No exceptions to the peril.

 The value of the loss is reasonable.

The duty of providing full particulars and proof of loss rests squarely upon the insured. He must prove to
the insurer that a loss has been caused by an insured peril. In practice, this may sometimes be difficult,
such as providing proof of a burglary. However, all reputable insurers allow a liberal interpretation of
what constitutes proof, and unless there are reasons for suspecting the integrity of the insured, the
insurer will virtually pay all claims.

In essence, since the insurer is holding the insurance fund on behalf of all policyholders, any payments
therefore should be completely warranted. This requires careful investigations and reasonable proof
both of the insurer's liability and of the amount involved. The services of a loss adjuster-are necessary in
claims processing. From the onset to the conclusion of the claim, loss adjusters being professionals are
involved in preserving the interests of the insurer which include:

• Checking that the cover was in force.

• Adequacy of the cover at the time of loss.

• Measures taken that minimizes the extent of the loss.

• Providing possible settlement amount.

• -Full description of the loss.

• Application of averages if appropriate.

• Steps of handling the claim.

The insurer's claims department officials in the hope of providing an equitable settlement then verify
these details.

• Claims settlement

The guiding principle in claims work is that there should be careful attention to detail and thorough
investigations, but "when liability is established payment should be made forthwith. Ordinarily, any
uncalled for delay will only result into loss of goodwill and possible future loss of business. Thus, a
prompt and fair claim payment has greater advertising value to the insurer, which is what they always
strive for. The settlement amount depends on the following factors:

• Nature of the cover

• The adequacy of the cover and

• Conditions that may limit the amount payable

The amount payable in the event of a claim is not subject of negotiation at the time of claim, but will
normally depend on among others whether it's a partial or total loss, where partial then the extent of
the damage/ destruction, amount claimed and excesses applicable will all be taken into consideration.
Ordinarily, life assurance claims are more straight forward and clearer than general insurance claims.

Methods of settlement

• Cash - most suitable method of settling claims and for liability and life claims is the only practicable
method available.

• Replacement - insurer replaces an article other than paying cash. This is usually applied in glass
claims, jewellery and furs.

• Repair - an adequate repair constitutes an indemnity. This settlement is particularly common, in

motor vehicle claims.

• Reinstatement (provides "new for old") - found in fire insurance and concerns the restoration or
rebuilding of premises (not necessarily on the same site) to their former condition.

6.10. Disputes settlement

Few claims give rise to disputes as to either the liability of the insurer to settle the claim or to the
amount of settlement or the speed of processing the claim.

Methods of dispute settlement

• Courts of law

• Arbitration

• Insurance Ombudsman Bureau

Disputes referred to courts of law are those where the insured disagrees with an insurer about whether
a claim is covered by a policy and the liability of the insurer to pay. After casing the courts' ruling will be
binding to both parties. Policies do carry an arbitration condition that specifies that disputes concerning
the amount payable and/or the liability under the policy should be referred to an arbitrator.

An arbitrator is an independent professional who looks at the pros and cons of the case and makes a
judgment. An arbitrator's judgment is not final and in case of disagreement the case shall be referred to
the legal courts for determination.

The ombudsman bureau is an independent institution for dealing with disputes in some countries such
as UK. It only deals with personal insurances and not business insurances and resolves disputes
concerning policy terms, amount payable and delays in settlement. The insured can accept or refuse the
ombudsman decision. Incidentally, the claimants can only refer their cases to this bureau only if the
insurer is a member.

6.11. Claims reserves

These are accumulated funds, which enables insurance companies to sufficiently finance their claims as
they arise. Reserves are basically grouped into:

• Technical reserves

• Free reserves

• Technical reserves

These are to cover outstanding liabilities to insureds and are subdivided into those that apply to general
business (non-life) and life business. Technical reserves for non-life business are divided into six:

a) Unearned premium reserves - this is a segment of this year's premium income that corresponds to
the policy year of the next accounting period.

b) Un-expired Risk Reserves - when there is an unexpected high claim and the unearned premium
reserve is inadequate to service the liabilities it is used to increase the required reserve level.

c) Outstanding claims reserves - this is a reserve created for reported claims but unsettled during the
particular accounting period) Incurred but not reported reserves - this reserve caters for those losses
that have occurred during the particular accounting period but not reported.

e) Catastrophe reserves - the reserves are for exceptionally worse claims experience.

f) Claims Equalization reserves - these are reserves created when there is a better performance in
returns to provide for a bad year of performance.

In life business, during the early years the actual risk is less than the premium paid. The excess
premiums are invested and accumulate a stable fund out of which future claims are paid. The invested
amounts earn interest and capital gains, which may profit the insurer.

• Free reserves

This is the second classification of claims reserve. The free reserves in non-life business are known as
shareholders funds. They are not for any specific liabilities and are used in expanding the company.
Being the capital base, part of it is retained to maintain solvency. The other part is for dividends to
shareholders and to finance contingencies. In life business the free reserves thus form the profit or the
excess. Other reserves for unexpected claims may be withdrawn from these free reserves. The residual
profit is then divided between shareholders and policyholders.
TOPIC SIX

RISK MANAGEMENT

INTRODUCTION

Risk management is not aimed at avoiding risks. Its focus is on identifying, evaluating, controlling and
"mastering" risks. Risk management also means taking advantage of opportunities and taking risks
based on an informed decision and analysis of the outcomes.

Risk management can be defined as the identification, measurement, analysis and control of those risks
that can cause losses to an enterprise. In the ideal situation, risk management involves a prioritization
process whereby risks are handled in a descending order, beginning with those risks which could cause
the biggest loss and has the highest chance of occurrence being handled first, and those with least loss
and the lowest chance of occurrence handled last.

The purpose of risk management is to eliminate or reduce as much as possible, the losses resulting from
a particular risk. The strategies used includes transferring the risk to another party, avoiding the risk,
reducing the negative effect of the risk, and accepting some or all of the consequences of a particular
risk.

Risk management is broader than insurance in that it deals with both insurable and uninsurable risks as
well as other appropriate non- insurance techniques of dealing with both types of risk. Risk management
therefore also involves techniques other than insurance.

BENEFITS OF RISK MANAGEMENT

There is certainly a strong case for implementing risk management due to the benefits that are obtained
from it. These include

1. Achievement of organizational objectives.

The organization is better able to focus on business priorities. It also enables managers to focus their
resources on the primary objectives. Resources are not re-directed to deal with problems. Taking action
to prevent and reduce losses, rather than cleaning up after the losses have occurred is in fact an
effective risk strategy that results in increased confidence of shareholders and managers.

2. Risk management leads to a cultural change that supports open discussion about risks and potentially
damaging information. The new culture tolerates mistakes but does not tolerate hiding errors. Also, the
culture emphasizes learning from the mistakes which leads to improved financial and operational
management by ensuring that risks are adequately considered in the decision-making process.

3. Improved operational management will result in more effective and efficient service delivery. By
anticipating problems, managers may have more opportunity to react and take action. The organization
will be able to deliver on its service promise by strengthening its planning process and helping
management identify opportunities.

4. Proper risk management enables a business to handle better its exposures to accidental losses in the
most economical and effective way.

5. It also enables a business to handle better its ordinary business risks. Freed from concern about the
accidental losses, a business can pursue more aggressively and effectively its regular activities.

6. If a business has successfully managed its pure risks, the peace of mind this brings about allows the
managers to undertake new attractive speculative risks that they would otherwise seek to avoid. This
peace of mind is made possible by sound management of pure risks may by itself be a valuable non
economic asset because it improves the physical and mental health of the owners, managers and the
employees who would be affected by losses to the firm.

7. The quality of its decisions is improved by considering how these decisions would affect the firm’s
exposure to accidental losses. By alerting the managers to the risk aspects of ventures, risk management
improves the quality of the decisions regarding such ventures.

8. Proper risk management may make the difference between survival and failure. Some losses such as
the destruction of a company’s factory may so cripple the company that without proper advance
preparation for such an event, the firm may be forced to close down.

9. Proper risk management can contribute directly to business profits through preventing or reducing
accidental losses as a result of taking certain low cost measures to handle minor losses, through
transferring potentially serious losses to others at the lowest possible fee, through electing to take a
chance on small losses unless the transfer fee is a bargain, and through preparing the firm to meet most
economically those losses that it has decided to retain.

10. Proper risk management can reduce the fluctuation in profits and cash flows. Wild fluctuations in
cash flows can cause a big challenge in carrying out business activities. Stable profits make it easy for a
firm to raise capital as investors prefer a company with stable earnings record than one whose earnings
are unstable.

11. Through advance preparations, risk management can in many cases make it possible to continue
operations following a loss, thus enabling a firm to retain its customers and suppliers who might
otherwise turn to competitors.
12. Professional risk managers and insurers contribute significantly by stabilizing businesses through the
indemnities they provide, the accidents they either prevent or reduce in severity, the long term projects
which they invest in, and the security, they provide by reducing uncertainty.

WHY STUDY RISK MANAGEMENT

We can personally benefit from a study of risk management in the following ways:-

Most people become risk managers at some point in their professional careers.

Even if we don’t become a professional risk managers, our activities will affect the organizations risk
exposure and we will in turn be affected by the organizations risks.

We can build professional careers in risk management consultancy.

We all have exposures in our lives which we must learn to manage.

TOPIC SEVEN

RISK MANAGEMENT OBJECTIVES AND POLICY STATEMENTS

Risk Management Objectives

Risk management objectives are formulated in line with the general management objectives and should
be done with the assistance of general management. Thus it is clear that risk management objectives
have to be responsive to and supportive of those objectives set by general management.

A firm’s objectives are influenced by the nature of its environment (clients, suppliers, and government,
etc.)

The specific company attributes that can affect risk management objectives include:-

(a) The company development and history.

(b) The personalities and experience of present managers.

(c) The nature and amount of company assets.

(d) The nature of the company’s operations.

General management objectives

General management objectives are directed towards specific goals. These objectives are:

1) Survival. Keeping costs below a threshold beyond which they could threaten the continued
survival of the firm.

2) Economy. Keeping total risk management costs to the lowest practical level.

3) Earning stability. Limiting unforeseen reduction in earnings or cash flows caused by losses to
‘acceptable’ limits.

4) Uninterrupted operations. Resuming normal business operations with minimum delay following
a loss especially for activities that are critical to the organization. This requires advance planning
for unexpected contingencies and possible commitment of resources prior to loss.

5) Continued growth. Continuing the firm’s growth. This may require commitment o resource prior
to any known loss.

6) Good citizenship or social responsibility. Limiting losses to employees, suppliers, customers and
members of the general public. The motivation of this objective maybe strictly humanitarian the
desire for good public image or some combination of these two motivations.

7) Satisfaction of externally imposed obligation. Complying with record keeping requirements

such as required filling of returns and reports by state authorities.

8) Acceptable level of worry and anxiety. Peace of mind.

These objectives can be classified according to whether they are likely to apply to a firm’s action:

1) Before loss

2) After loss

The pre loss objectives include: economy, an acceptable level of worry and anxiety.

The post loss includes; survival, earnings stability and satisfaction of externally imposed obligations can
be either pre-loss or post-loss objectives. From these objectives, the risk management department could
formulate its own objectives in line with and supportive of these general objectives. Examples of
possible risk management objectives include:-

1. To promote an active loss prevention programs to eliminate or reduce as far as practicable

potential causes of losses.

2. To operate self-insurance in schemes where it is essentially justified.

3. To purchase commercial insurance in residual areas of risk exposures at the least possible cost.

4. To reduce as much as possible the cost of risks to the firm that may endanger its solvency.

5. To transfer to others the risk of loss to the firm which shall exceed Shs X and to assume any loss
less this amount

6. To employ the techniques of loss prevention to the maximum extent possible.

The Risk Policy Statement

The risk policy statement is prepared by the risk manager and approved by general management
preferably the board of directors. The risk policy statement defines the authority and responsibility of
risk manager. The policy statement is central to the risk management function since the risk manager
needs to know in specific terms the attitude of the top management to risk and therefore participates in
the task of drawing up the policy statement. A risk management policy should reflect the corporate
goals of the firm.

Risk management activities must get the support of the top management through the formulation of a
written risk policy statement. The risk policy statement will vary from firm to firm and is usually worded
in fairly general terms but may contain among other things the following:-

 Define the corporate philosophy of the firm towards risk management as decided by the board
of directors.

 Recognize the status and function of risk management as a separate and critical management
function in the organization.

 Make clear the position taken by the top management in such matters as safety, loss
prevention, and risk transfer as well as risk avoidance.

 Provide for all departments and all levels of management to co-operate in the performance of
risk management activities.

 Assign risk management responsibility to a specific department.

 Delegate appropriate authority to the risk manager to act for top management in maters
relating to risk.

 State the scope, authority and limitations placed upon the risk management department.

 Define the guidelines on the techniques and measures to be employed in dealing with the
potential losses.

 Define the types of losses to which the firm is exposed

 Define areas of risk where self-insurance schemes are to be operated

 Give guidelines for judicious purchase of commercial insurance.

BENEFITS OF POLICY STATEMENTS

1. They serve in a broad way as a set of rules to follow and lay constraints to action

2. The statement gives recognition to the importance of the risk management function.

3. It indicates support from the top management.

4. It ensures participation by all functional management in risk management activities

 5. It helps the risk manager to perform his functions effectively as his authority and responsibility
are clearly defined

6. Top management is relieved of decision making in day-to-day affairs of risk management.

Disadvantages

1. If the statement is couched in broad terms it may offer no guidance at all; if it is too specific it
may pose constraints for effective risk management thereby inhibiting the use of initiative on
the part of risk manager.

2. Risk managers may lose their resourcefulness in order to be within the risk framework of the
policy.

TOPIC EIGHT
RISK IDENTIFICATION

Risks are events that could cause losses. After establishing the objectives of risk management and
defining the risk management policies, the next step in the process of managing risks, is to identify risks.
It becomes necessary to dig into the operations of the company and discover the risks to which it is
exposed.

Risk identification requires a thorough knowledge of the organization and its operations. The risk
manager needs a general knowledge of the goals, policies and functions of the organization. What it
does and where it does it. This knowledge can be gained through inspections, interviews with
appropriate persons within and without the organization, and by examination of internal records and
documents.

If potentially dangerous gaps in one’s knowledge are to be avoided, the first part of the risk
identification process must aim to discover every possible risk factor that may be associated with:

(a) The organizations own activities, including:

(i) The nature of the activities. That is what sort of business it is in. These activities may themselves be
risky or relatively safe. They may be the source of the risk.

(ii) The manner in which the organization undertakes its activities such as, the production methods it
employs, whether any work is subcontracted, who its suppliers and customers are, and so forth.
Sometimes the activity is itself relatively safe but the way it is being carried out could be very risky. A
loss can occur because of the way a relatively safe activity is carried out.

(iii) Where it carries out its activities, for example, servicing work done at
customer’s premises, and the final destination of its products. The
location in which the activity is being carried out can itself be a source of
risk. Risk can emanate from the physical characteristics of the place in
which the activity is being carried out.

(b) The physical, legal, and political environment in which it operates.

Here one is for example, concerned with legal provisions relating to responsibilities for injuries arising
from defective products, the speed of the judicial processes, exposure to political risks, natural
catastrophes, and so forth.

It is not possible to generalize about the risks that a given organization will face. This is due to:-

(l) The differences in the kind operations in which the different organizations engage.
(ii) The different conditions and circumstances in which the organizations operate that give rise to
different risks.

The task of risk identification breaks down into two sub parts, namely:

(a) The perception of risk. That is the ability to perceive that there is an exposure.

(b) The identification of the operative cause or perils, coupled to the likely result.

Before considering the various techniques that may be employed in this risk identification process, three
points must be made.

(i) No single method is likely to reveal all the risks to which an organization is exposed, so that several
techniques must be employed.

(ii) Because of budget constraints and the fact that increasing effort is likely to yield diminishing returns,
a risk manager must select those methods which in his situation promise the best results.

(iii) Risk identification must be an on going process: organizations are dynamic not static beings, and
even the most stable and conservative organizations exist in a changing world.

The task of identifying risks can either start with the source of losses, or with the problems that can
cause losses.

APPROACHES IN RISK IDENTIFICATION

The following approaches can be used in risk identification.

(a) Source analysis. Risk sources may be internal or external to the system that is the target of risk
management. Examples of risk sources are: stakeholders of a project, employees of a company.

(b) Problem analysis. Risks are related to threats. For example: the threat of losing money. The threats
may exist with various entities, most important with shareholders, customers and legislative bodies such
as the government.

(c) Reports. A scan of various reports such as auditor’s reports, safety audit reports, loss assessor’s
reports at the time of claims for insurance, etc. will reveal the potential areas of events that can result in
financial loss to the business.

(d) Inspections. A physical inspection by risk inspectors can also reveal potential losses and the risks
associated with them.
(e) Financial statements. A careful study of the various items in the financial statements can reveal
potential risks. The main financial statements are the balance sheet and the income statement. All the
critical items in the financial statements are assessed for risks.

Common risk identification methods arc:

(f) Objectives-based risk identification. Organizations and project teams have objectives. Any event that
may endanger achieving an objective partly or completely is identified as risk.

(g) Scenario-based risk identification. Different scenarios are created which may be the alternative ways
to achieve an objective, or an analysis of the interaction of forces in, for example, a market or battle.
Any event that triggers an undesired scenario alternative is identified as risk.

(h) Taxonomy-based risk identification. In taxonomy-based risk identification is a breakdown of possible

risk sources. Based on the taxonomy and knowledge of best practices, a questionnaire is compiled. The
answers to the questions reveal risks.

(i) Common-risk Checking. In several industries, lists with known risks are available. Each risk in the list
can be checked for application to a particular situation.

(j) Risk Charting This method combines the above approaches by listing
Resources of risk, Threats to those resources, Modifying Factors which
may increase or reduce the risk and Consequences it is wished to avoid.
Creating a matrix under these headings enables a variety of approaches.
One can begin with resources and consider the threats they are exposed
to and the consequences of each. Alternatively one can start with the
threats and examine which resources they would affect, or one can begin
with the consequences and determine which combination of threats and
resources would be involved to bring them about

RISK IDENTIFICATION TOOLS

To reduce the possibility of failure to discover important risks facing the firm, most risk managers use
some systematic approach to the problem of risk identification. Some of the more important tools used
in risk identification include the following:-

Financial Statements

Analysis of financial statements may be a useful tool in helping the risk manager to identify sys-
tematically various company risks and to ensure that important items are not omitted.

(a) The Balance Sheet. This financial statement provides a summary of all the assets of a given
organization. These assets are subject to loss through particular risks. A detailed examination of each
asset item in the balance sheet can reveal information relating to the risks that could cause loss or
damage to the asset. Every liability item in the balance sheet could also expose the organization to a
particular risk. Examples of such an analysis include the following:
1 Cash. Management of company cash may involve risks of physical loss while cash is being taken
to the bank for deposit. The perils of forgery, theft, bank failure, employee infidelity, as well as
physical destruction represent sources of possible loss of cash. The management of petty cash
as well as bank deposits should be reviewed. Adequacy of safes and internal control procedures
should be examined. In one case a bookkeeper stole a large sum of money from a stamp fund
over a period of twenty years. The thefts were not detected by normal auditing procedures
because each individual theft was small.

2 Securities. Securities may be lost in much the same manner as cash. Some firms keep securities
on their premises instead of in banks. The risk manager should institute procedures to reduce
the risk of loss of securities after a thorough review of management systems over these assets.
In one case the risk manager arranged to have brokers deliver newly purchased securities
directly to the bank so as to avoid any risk of loss from internal corporate handling.

3 Accounts receivable. Company assets represented by accounts receivable are subject to loss by
many perils other than the obvious bad debt losses. Above-normal loss may stem from
destruction of the debtor's plant due to uninsured perils, death or disability of the debtor,
dishonesty or business incompetence of the debtor. Accounts may be uncollectible because the
debtor has a legal complaint against the seller stemming from misrepresentation of the goods,
false advertising, or failure to honor warranties. Finally, accounts may be concentrated among a
small number of customers, thus increasing the relative risk of loss due to any of the above
perils which happen to any one account.

4 Inventories. The risk manager needs to examine detailed information on the types of inventories
used, where they are located when they are scheduled to be used, the ease and speed with
which alternative source of supply may be arranges, how hazardous inventories are used and
stored, who is responsible for the safety of each type of inventory, and the particular hazards
that may characterize each class of inventory—e.g., explosive or inflammable items.

5 Buildings and equipment. In risk management audits it is common to find that many building
and equipment exposures are either overlooked completely or carry duplicate insurance
coverage. A formal review of all such items carried as assets is necessary for sound risk man-
agement. Many of the questions noted above for inventories should be asked for buildings and
equipment as well. In addition, buildings in the process of construction, leased equipment and
buildings, elevators, generators, boilers, and fuel tanks carry special hazards that usually require
the attention of the risk manager. Thus, the firm may wish to insure the builder’s risk and to
ascertain the continued maintenance of liability and workers’ compensation coverage by the
builder. Obligations under contracts may expose the firm to certain losses, for example, a lease
or purchase agreement may require assumption of liabilities for negligence of others.

6 Automobiles. Although autos and trucks are not usually identified separately on the balance
sheet, most firms have a large exposure to loss from this source which requires sound risk
management procedures. Questions are raised as-to who drives each car or truck, how distant
the operation is from headquarters, the extent to which employee-owned or hired cars are used
in company business, extent of liens, replacement costs, and so forth.
 7 Miscellaneous assets. The risk manager must exercise considerable alertness to detect unusual
asset exposures. In one case the risk manager of a large farmers' cooperative realized that the
firm had an exposure of loss to catfish grown in farmers’ ponds under special contracts. He
negotiated insurance coverages against loss by water pollution, forest fire, and other perils. In
another case the risk manager of an electrical utility recognized that wafer behind a dam was in
fact an asset subject to loss, since dam breakage would result in loss of revenues from water-
powered electric generators. A decision was reached to insure the water against such loss.

8 Accounts or notes payable. An investigation of payables may reveal exposures to loss of

concern to the risk manager. For example, if payments must be made in foreign currency, a risk
of loss exists from increases in the market price of this currency at the time of payment of the
account. As another example, an investigation of a note payable or bonds may reveal that the
creditor requires the firm to maintain certain insurance on property purchased with the loan
proceeds. Obviously, the risk manager must investigate these matters and see that his firm is in
compliance.

9 Financial solvency. The risk manager should be concerned with the ways in which the general
financial position of the firm affects pure risk management. Obviously, when there is a weak
statement (e.g., large liabilities in relation to assets), the firm’s credit at the time of a fire or
other catastrophe will be less than it might otherwise be. In some cases, the risk manager may
work with the treasurer to arrange standby bank credit as a substitute for insurance.

The Income Statement: Analysis of the income statement can also be of great help in the process of risk
identification. The following items are illustrative:

1. Sales. Analysis of the composition and type of sales revenues may answer questions about
risks of loss from foreign sales, sales on credit, dependence on a few customers, sales
dependent on franchises or licenses which could be lost by failure to meet certain
requirements, product liability, seasonality of sales, terms of sale, and so forth.

The risk manager should ask questions such as these: Do terms of sale require the firm to carry
transportation insurance? To what extent will sales be hurt if the manufacturing plant is shut down
wholly or partially by fire? How will sales be affected by a shutdown at a supplier’s or customer’s plant?
To what extent will interruption of the business result in permanent loss of customers, and what steps
should be taken to minimize this loss?

2. Miscellaneous income. In some cases examination of miscellaneous sources of income may

lead to-discovery of certain risks. For example, the existence of rental income may point to
real estate the firm owns. Is this real estate properly protected? Income from a franchise
might point to a liability risk resulting from acts of the franchisee which could cause loss to
the risk manager’s firm.

3. Expenses. An analysis of expense items can often reveal a host of potential risks. Direct
labor expense reflects the industrial accident exposure. Wage agreements will usually
contain obligations for insurance coverage on employees and other employee benefits.
Analysis of travel expenses can reveal the location and type of travel, including use of
 employee cars and hired cars, employment of temporary help by salesmen, or use of
watercraft or aircraft. Rental expense can pinpoint the existence of risks in connection with
leased property. Research and development expense may reveal risks in areas outside the
normal operations of the firm and should be examined carefully by the risk manager. Finally,
the risk manager can determine the extent of fixed expenses, those which must be met
even if the business is shut down by some fortuitous event. In many cases the business
interruption loss is greater than direct loss from perils such as fire, explosion, or windstorm.

Insurance policy checklists.

Because insurance management is the older field, the technique of identifying insurable exposures was
already highly developed when the risk management movement began.

Insurance companies created insurance policy checklists, which identify the various risks for which they
offered insurance coverage.

They also developed extensive application forms for various types of insurance that elicited information
about hazards that need to be reflected in rating and underwriting decisions.

Although these tools naturally focused on the perils and hazards against which insurers offered
protection, they provided a base on which risk identification methods could be constructed.

Many of the tools that had been used by insurance agents and insurance managers to identify insurable
exposures were expanded and adapted to aid in the identification of other risks for which the risk
manager is responsible.

The simplest and most often used method is by the completion of a checklist of perils/hazards. The
checklist is used as an aide memoir where each peril or hazard is considered in relationship to the
business operations. For example, the peril of flood would lead to a consideration of the location of the
prime operations and the potential for inundation from the sea, flashfloods, storm-water drainage
backing up, burst river banks, etc. Similarly, in analysing fire and explosion risks, consideration in respect
of each of the buildings and sites owned and/or occupied would need to be given to:

potential sources of ignition or explosion from both inside and outside the premises, such as electrical,
chemical, heating and process hazards; the security of the premises against arson; the occupation of
adjoining and adjacent sites and premises: and

those features which influence the spread and so size of any loss, notably the type of construction -
materials, number of storeys, fire breaks, etc; - whether sprinklers, drenchers or other fire extinguishing
or alarm equipment are installed; the nature of the contents; distance from the nearest public fire
brigade.

The form which a check list takes is largely a matter of personal preference, but it will need to cover:

all types of assets which arc owned or used by the organisation or for which it may lie responsible. The
list should cover not only obvious physical assets - its buildings, machinery, stocks, vehicles, vessels,
mineral deposits, pipelines, land and so forth - but also intangible assets (such as patents, copyrights,
royalties, designs and information systems}, and personnel.
account must also be taken of other facilities upon which the business is dependent (like public utility
supplies, road and rail access, and water from rivers and lakes), and the physical, natural, social,
economic, legal and political environments in which the organisation operates.

sources of exposure to loss-producing events, Here one must not think solely in ''terms of insurable
perils: it is possible that the major threats to the business may arise from events for which insurance is
not readily available, such as industrial espionage.

factors bearing on the size of losses that occur. Examples have already been given above in relation to
potential fire damage. To take one more case, in considering products liability one would need to check
the nature of the production process (i.e. batch or continuous); the standard and frequency of quality
control checks; the legal position in the country of use regarding liability for defective products and any
limits on awards for injury or damage.

Once a check list has been compiled, the risk manager will probably be able to obtain many of the
answers without leaving his own office. There are many facts, however, that can only be established by
on-the-spot inspections, such as standards of maintenance and housekeeping, which have such an
important bearing on exposure to losses arising from fire, explosion, industrial accidents, and product
defects.

The major weakness of the check list is that it draws attention only to the perils and hazards listed, with
the result that other potential sources of loss may be overlooked.

Risk analysis questionnaires

The checklist is therefore used in developing an orderly review of loss exposures.

Insurers have developed a lengthy survey form designed to obtain information on nearly every aspect of
the operations of any business firm, large or small. It is organized according to the major types of
insurance exposures, such as those relating to crime, transportation, physical loss to buildings and
contents, business interruption, motor vehicles, etc.

Questions are developed to elicit information needed to insure losses and are arranged according to the
type of insurance available. For example, in analyzing fire and explosion risks, consideration is made in
respect of each of the buildings and sites owned or occupied, with special attention to:

Potential sources of ignition or explosion from both inside and outside the premises, such as electrical,
chemical, heating and process hazards.

The security of the premises against arson.

The occupation of adjoining and adjacent sites and premises.

Those features that influence the spread and so the size of any loss, such as the type of construction –
materials, number of storey, fire breaks, and whether sprinklers, drenchers, or other fire extinguishing
or alarm equipment are installed. The nature of the contents, the distances from the nearest public fire
brigade.

The form that a checklist will take is largely a matter of personal preference, but it will it will to cover:
All types of assets that are owned or used by the organization or for which it may be responsible .the list
should cover not only the obvious physical assets, but also the intangible assets such as patents,
copyrights, royalties, designs, information systems, and key personnel.

Account must also be taken of other facilities upon which the business is dependent like public utility
supplies, road and rail access, and water from rivers and lakes, etc. account must also be taken of the
physical, natural, economic, legal and political environments in which the organization operates.

Sources of exposures to loss-producing events. Here one must not think of only insurable perils because
it is possible that the major threats to the business may arise from events for which insurance is not
readily available, such as industrial espionage.

Factors bearing on the size of losses that occur such as the nature of the production process, the
standard and frequency of quality control checks, the legal position in the country of use regarding
liability for defective products and any limits on awards for injury or damage.

A checklist will provide information on the specific locations of property, special perils that exist, as well
as the nature and extent of insurance.

Once an appropriate checklist has been developed, the risk manager may obtain many of the answers
without leaving his office. But the risk manager should attempt to identify, as closely as he can, exactly
what loss the firm would suffer if the property were destroyed. How it might be destroyed, what public
or employee liability the firm faces in its operations, and how the firm proposes to deal with the
situation in each case. In this way the chance of overlooking important exposures is reduced, and the
chances of insuring values that are inconsequential nature is also reduced.

There are many facts that the risk manager can establish by on the spot- inspections, such as standards
of maintenance and housekeeping, which have such an important bearing on the exposure of losses
arising from fire, explosion, industrial accidents, and product defects.

The major weakness of the checklist is that it draws attention only to the perils and hazards listed, with
the result that other potential sources of loss may be overlooked.

Many risk exposures that a risk manager must deal with may be unique to the firm. Therefore the
checklist employed in a given case must be tailored specially for a given firm, after careful evaluation of
the exposures faced by the firm. Once prepared, it must be updated at least annually.

An advantage of the checklist is that it warns the management of the firm to study loss exposures and to
make decisions on matters formerly neglected.

Threat analysis

An alternative approach to the checklist is to compile a list of the threats to the business. Take, for
example, the threats of denying access to the place of business for which the completed form may
appear as in Table 4/2. Denial of access to premises.

Table 4/2. Threat analysis

An alternative approach to the check list is to compile a list of the threats to the business. Take, for
example, the threat of denying access to the place of business for which the completed form may
appear as in Table 4/2. Denial of access to premises

Table 4/2 Threat analysis

Threat Cause Result Mitigation Loss assessment

factor

Damage Business
interruption

Denial of access strike Partial closure Good industrial Nil 2-5 weeks
or total closure relations

Total closure suppliers not

pickets Nil 1-2 weeks
vulnerable
Total closure

second access
road subsidence to rear through Nil
adjoining
factory yard

Loss of services burst main Total loss of Second supply Nil 1-2 days
process and available
water forst
usable water
In catchment
drought Nil Prolonged
Partial loss likely area with high
seasonal
to cause reserve capacity
period
cessation of
operations

can arise from many causes, for example quarantine regulations following epidemic, collapse of nearby
buildings blocking the road, burst water/gas mains preventing access, strike picketing, government
order (for example, a prohibition order issued by the Health and Safety Executive), and so on. The
threats to the business in terms of both the severity and duration of the interruption probably would
vary as shown.

Organization charts

Organisation charts can be a useful starting point in that they may reveal various facts about:
The nature and extent of the organisation's activities. For example, a large conglomerate may be split
into subsidiary companies specialising according to types of product, and possibly with further divisions
into home and overseas companies;

Inter-relationships and inter-dependencies between various parts of the organization.

the breakdown of the organisation into individual profit and cost centres, which arc facts to he
considered when risk financing decisions have to be taken;

the people with the authority to participate in making and implementing risk-handling decisions, and
those who may be able to help in providing technical and oilier information which the risk manager may
require;

Any organisational weaknesses which may exacerbate risk situations; for example, the Flixdorouph
inquiry revealed that there had been no qualified mechanical engineer on the site to supervise
maintenance work.

Accounting records

The records maintained primarily for accounting purposes are not only another source of qualitative
information, hut also provide, for example:

some of the data required for the valuation of buildings, plant, stock and other assets;

data for quantifying inter -dependencies between different parts of an organisation, and its dependency
upon particular suppliers and customers:

details of an organisation's financing arrangements and its financial position;

past expenditure on handling risks and the costs of losses that have occurred.

Published accounts are of limited value, though not without their uses. Most large companies go beyond
the minimum requirements of the Companies Acts in publishing details of their activities, and provide a
breakdown of turnover, and possibly earnings, among their various product and geographical divisions.
Also, the accompanying chairman's report may provide further insight into the company's activities and
plans for the future.

Far more revealing, however, arc internal accounts. In particular, nominal accounts and cost/profit
centre accounts should repay careful study. The nominal ledger and cost accounting code designations
should give an indication of not only the type(s) of business undertaken, including details of suppliers,
.subcontractors and customers, hut also of methods of financing the business, likely cash constraints,
and the ability to withstand unplanned losses. For example, the examination of the books of a wholesale
and retail business wild a number of sales outlets probably would disclose: any vulnerability to sole
sources of supplies; indebtedness to major suppliers; the breakdown of turnover and earnings between
the various outlets, types of goods and customers; stock turnover rates; the fixed clement of total costs;
and its ability to earn revenue on a day-to-day basis. Such information would give some indication of the
susceptibility of the business to bankruptcy in the event of any interruption from such causes as damage
to any of its own or suppliers' premises, inclement weather or any obstruction which prevents
customers from paining access to its premises.
Any activity that involves a financial transaction will appear somewhere in the accounting records. For
example, from purchases and sales accounts it is possible to obtain details of suppliers, customers, and
analyses of purchases and sales of various materials and products in order to establish the extent of
dependence upon any one supplier or customer. Likewise, rent items will reveal whether any buildings,
plants, vehicles or other equipment arc leased.

Other records

Organisations keep many other records that can reveal facts about exposure to risk; for example:

leases specify who is responsible for repairing damaged properly;

construction contracts and sub-contracts assign responsibilities for damage or injury to persons arising
out of the contract work;

purchasing and sales conditions may deal with questions of liability for damage or injury caused by
defective products:

After-sales servicing records may point to potentially dangerous defects in products.

The clearest evidence of what may happen is that which is provided by records of past losses, including
details of insurance claims. Such records not only provide evidence of potential sources of loss but also
of loss probabilities and severities, so that they are also of considerable value for risk measurement
purposes.

What organisation charts, accounts and oilier records do not reveal are work processes find the physical
layout of plants; to obtain that information one can proceed to the examination of flow charts.

Flow charts

Flow charts show the flows of materials, parts, and products from suppliers, through the various
production stages and on to customers. By pinpointing potential bottlenecks, they reveal the
vulnerability of the business to risk, particularly when such diagrams are then translated into layout
drawings where potential hazards can be plotted against bottleneck exposures.

A simple flow chart is not complete, however, unless some quantitative throughput or value-added
dimension is included. For example, it is possible to see from figure 4/1 dial most of the parts produced
have to be painted, and that the finished parts store receives all of the parts before passing them on for
final assembly. However, it is not clear what proportion of total production has to be painted, nor where
the division between the wood machining and metal machining operations is in relation lo total
production. Such information is available from the schematic flow chart in figure 4/2, which more clearly
reveals the degrees of interdependence between the various parts of the factory, and dependence on
suppliers and customers. Besides illustrating the production flows, it also shows the values transferred
from one stage to another, and the values added (that is, labour, materials, and overhead costs) at each
singe. Amongst oilier things, the following points can be ascertained from the diagram:
plastic parts are obtained from just one source, and possibly certain of the metal parts and sundry items
may be in the same position;

up to the machining and heal treatment stages, woodworking accounts for almost 45% of production
against 55% from metal working;

clearly the paint shop is critical to production, only a negligible part of the metals parts not being
painted;

a third of the output is sold to one customer.

The information obtained from, and the points raised by, the diagram can then form the basis of an
exposure investigation covering such question as:

How dependent is the manufacture of wooden toys upon metal parts produced in the factory?

If for nay reason there were a prolonged stoppage of production in the press shop, could metal parts for
the wooden toys be bought in?

Could plastic parts – and any other parts for which there may be a sole supplier – be purchased from any
other producer?

Where are patterns and moulds stored?

What is the source of power?

How soon could alternative warehouse facilities be obtained in the event of the loss of the finished
goods store?

Event analysis

'Event' analysis is a technique for considering likely events which could cause problems and then
investigating causes and effects. It is illustrated in figure 4/5. The varying impact between cause and
effect is a function of the 'event'; for example, consider the event as failure of boiler services. There are
many potential causes, ranging from that of explosion, to burst water tube, to failure of the priming
pump. The effect of these three causes giving rise to the same event would be quite different. An
explosion could lead lo major interruption of processes, the destruction of property, and loss of life,
including potential third partly liability. On the other hand a burst tube may result in only minor
interruption, with no property damage or personal injuries. At the other end of the spectrum, the failure
of the water priming pump may have no effect at all if a standby pump can be brought into service
immediately.

Figure 4/5 Event Analysis

CAUSE EFFECT

LIABILITY DAMAGES

PROPERTY DAMAGES
 NATURAL
PHENOMENA

BREACH OF NATURAL
LOSS
LAWS PRODUCING
EVENT

MAN’S ACTIVITIES

Such analysis can be aided by the use of hazard logic trees (HLT) whereby the various hazards which may
precipitate the operation of the peril which is the cause of the loss producing event can be identified. As
the name implies, it is simply another technique for forcing one lo carry through the exposure analysis
process in a methodical, logical manner.

In order to illustrate the technique, figure 4/6 lakes the example of another type of loss-producing-
event. the loss of warehousing facilities. The lists of hazards shown arc not exhaustive, and those
applying in any particular case will be dependent upon local circumstances. Imagination plays an
important role in the construction of HLT.s. and the prima facie remoteness of either perils or hazards
docs not justify their omission from the lists: far too frequently it is the unexpected event which docs
occur.

At the outset of this chapter the relationship between risk identification and measurement was
mentioned. One advantage of constructing HLTs is that it forces one lo break down the potential causes
of loss-producing events into their smallest components, (hereby providing at least a subjective pointer
to the probability and severity of those events. It is also of value at the risk-handling stage, in that the
identification of hazards is a prerequisite to the implementation of measures to control them.

Hazard operability

Such a study is designed lo be used at the planning stage of a new plan. The objective is lo examine the
process as a whole in order to identify potential deviations from normal operating conditions, their
causes, and possible consequences.

The technique which was developed by Imperial Chemical Industries Limited, is for a small team lo
examine every stage (if ,1 process by applying a number of guide words as shown in Table 4/3.
Figure 4/6 Hazard logic tree

RISK Loss producing event loss of

storage facilities

PERIL Fire or Water damage Other forms Denial of

explosion of damage access

 Arson  Flood  Aircraft  Flooding

 Smoking  Storm  Vehicle impact  Subsidence of roads
 Electrical\heating  Bust pipe or other  Malicious damage  Closure of roads
 Spontaneous apparatus (riot, strike)  Epidemic
combustion  Burst water main  Subsidence  Government order
 Spillage or leakage of  Earthquake
flammable liquids  Hurricane

H  Chemical interaction
 Boiler explosion
A
 Spreading of fire
Z
from adjacent
A premises

R  Explosion in adjacent
premises
D

S
Table 4/3. List of guide works

Guide words For batch Meaning

For continuous processes Processes

NONE NO or NOT Complete negation of the design

intention.

MORE OF MORE Increase in flow, pressure, etc.

LESS OF LESS Decrease. in flow, pressure, etc.

PART OF PART OF Some of the intention is achieved

e.g. the composition of the system is
different from what it should be.

Additional component or phase

present or another activity occurs
concurrently

What else can happen apart from

MORE THAN AS WELL AS normal operation e.g. start up, shut
down, maintenance, etc.

Opposite of the design intention,

e.g. reverse How or chemical
OTHER reaction

Something quite different from the

design intention

REVERSE
 OTHER THAN

Figure 4/7 Fault tree analysis

Explosion in an open
paint spraying booth

Flammable paint spray Source of ignition

in explosive
concentration

Failure of Continuing flow Electrical spark Flames near Cigarette in or near

extractor fan of paint booth booth
 Failure of
Introduced by operative Introduced by
Breakdown of Failure of electricity earthling another person
system
equipment Safety audits
supply

A system that brings together the various techniques relating to both the perception of risk and the
identification of operative causes and peril is the safety audit. It has been defined as a critical
examination of an industrial operation in it’s entirely to identify potential hazards and levels of risks

In the guide the various elements of a safety audit arc set out in a fuller descriptor of such an audit
which described it as a study:

Subjecting each area of a company's activity to a .systematic critical examination with the object of
minimizing loss. Every component of the total system is included, e.g. management policy, attitudes,
training, features of the process and of the design, layout and construction of the plant, operating
procedures, emergency plans, personnel protection standards, accident records. etc. An audit - as in the
field of accountancy — serves to disclose the strengths and weaknesses, and the main areas of
vulnerability or risk, and is carried out by appropriately qualified personnel, including safety
professionals. A formal report and action plan is subsequently prepared and monitored.

An audit may be undertaken either internally, or by outside consultants, or by a combination of both. In

any case, a team will need to be assembled under the direction of a co-ordinator in order to provide the
range of skills and expertise required to tackle the various elements of the work. First, however, the
management must define the audit team's exact terms of reference: for example, is the study to be
limited to certain parts of the organisation's activities or to certain types of loss-producing events, or is it
to be wider-ranging, and if so what are its boundaries? The members of the audit team can then be
chosen to provide the technical skills required to carry out the defined study. Next, responsibility for the
different parts of the study (for example, fire and explosion safety, accident prevention, products safely,
statistical analysis of experience, contingency planning, etc.) can be assigned to the members of the
team. The first stage of an audit is to acquire a thorough knowledge of:

the organisation, its activities, and so forth:

All regulations relating to the safety of its operations and products.

Use may be made of available organisation and How charts, as described above, to provide the
background information for (a), supplemented by discussions with management, on-the-spot
inspections, and the analysis of records.

After assembling details of all safely regulations applying to the organisation, all aspects of compliance
must be checked. So, during an early stage of the study all documents pertaining to safety should be
examined, including in particular documents required by the Health and Safety at Work, etc. Act, 1974.
Such documents would include:
the organisation's safely policy statement

safely rules:

copies of notices and posters

plan inspection records; 4/12

When proceeding to the detailed analysis of the hazards and perils to which the various parts of the
organisation's activities arc exposed, it will be necessary to carry out on the spot investigations and
discussions with management and employees. Prior study of the nature of the operations before any
visit is made and the use of the son of techniques explained in the last section help to ensure that the
work is carried out systematically. Also investigation of certain types of potential loss-producing events
may require study by two or more members of the audit team. For example, when assessing the fire and
explosion risks, checks will need to be made on such general matters as

the fire resistance of buildings;

flammability of materials;

housekeeping standards

sources of ignition;

fire alarm and extinguishing systems:

security and security patrols

fire training of employees;

the proximity of the local fire brigade;

water sources;

means of escape.

However, in order lo deal with such matters as electrical installations, possibly hazardous processes, the
fire and explosion characteristics of chemicals, and such like, the help of experts in those fields may be
required.

The final stage of a safety audit is the preparation of a report providing:

an analysis of the risks to which the organisation is exposed:

recommendations for improving safety, listed in order of priority, and contingency planning too.

Thus a safely audit goes beyond the identification of risks to include risk evaluation and handling. Once
an audit has been carried out, provision should be made for the monitoring of proposed changes lo sec
that they arc implemented within an allotted time scale and to check on their results.
TOPIC NINE

STATISTICAL CONCEPTS IN RISK MANAGEMENT

The risk manager should have working knowledge of certain statistical concepts as a basis for
understanding risk management theory. The discussion here is not intended to be complete; basic
books on statistics should be consulted for a more elaborate treatment.

Probability. Probability is the chance of occurrence of a given event. In insurance situations probability
often is expressed as percentage of times which in the long run a loss-producing event will happen.
Thus, fire frequency may be stated as a probability of .5 percent per year (.005) in a given territory for a
certain type of construction.
Probability Distribution. A probability distribution is a listing of all possible events in a set together with
the probability that each event will occur. Suppose, for example, we are interested in studying how
accidents are distributed in a given plant which employs 1,000 men.

From past records over several years, the risk manager discovers that in 60 percent of the years there
were no accidents. In 20 percent of the years there was one accident, in 10 percent of the years there
were two accidents, in 6 percent of the years there were three accidents, and in 4 percent of the years
there were four accidents. A probability distribution describing these findings would appear as follows:

Possible event (accidents) Probability of occurrence

0 .60

1 .20

2 .10

3 .06

4 .04

Total 1.00

Theoretical Probability Distribution.

As mentioned in Chapter 2, theoretical probability distributions are those whose shape is established by
some mathematical formula. These distributions are useful because they possess known characteristics
which can facilitate the analysis of loss frequencies they describe. Examples of theoretical distributions
often used in insurance problems are the binomial, the normal, and Poisson. Each of these has complex
formulas which will not be given here. Examples of how theoretical probability distributions may be
useful follow.

Mean. The mean is an arithmetic average of a group of numbers. For example, the mean of a binomial
probability loss distribution may be given by the letters np where n is the number of possible events and
p is the probability of loss. Thus, if there are 100 automobiles, n would be 100 since it is theoretically
possible for all 100 autos to be involved in a loss. If the annual probability of loss is found to be 5 per-
cent, the mean annual loss would be .05(100), or 5 autos.

Standard Deviation. Standard deviation is a measure of dispersion of a probability distribution. It is also

the most widely accepted measure of risk. The larger (smaller) the variation of numbers in a probability
distribution from the mean, the larger (smaller) will be the standard deviation. For example, if a risk
manager learns that each year the number of deaths in a work force of 10,000 is, say, 10 and that this
number has never been less than 9 or more than 11, it is obvious that the dispersion, and standard
deviation, will be less than if the deaths ranged, say, from 5 to 15, averaging out to be 10.

In actually calculating standard deviation, one proceeds as follows. Assume that for the past five years
deaths in a work force have numbered 10, 8, 12, 13, and 7, respectively. The total is 50 and the mean, 10
deaths per year. Now calculate the deviation of each year's deaths from 10 and square the results. The
deviations are 0, 2, — 2, — 3, and 3. and the squared deviations are 0, 4, 4, 9, and 9, Next, sum these
numbers, take the average, and extract the square root. The sum is 26, mean is 5.2 (also known as the
variance), and the square root of 5.2 is 2.28, the standard deviation.

Standard error is the standard deviation of mean values taken from successive samples of data drawn
from a given population.

Coefficient of Variation. A way to gauge the importance of any standard deviation and to compare
different standard deviations as a measure of relative risk in different situations is to divide the standard
deviation by the mean. This measure is known as the coefficient of variation. In the above example, the
coefficient of variation is the ratio of 2.28 to 10, or .228, or 22.8 percent. A coefficient of variation is also
a useful way to express risk (uncertainty) and to compare the risk attaching to different sets of loss
exposures. In a typical situation, for example, the risk in automobile liability losses is much higher than
the risk in workers' compensation losses because auto liability losses are usually less frequent, but more
severe than industrial injury losses.

Confidence Intervals. In theoretical loss probability distributions, the analyst may state in advance the
number of losses which are expected to occur within different ranges of the mean—that is, within so
many standard deviations either side of the mean. In the normal distribution, for example, which is bell-
shaped, 68.27 percent of all of the numbers in the distribution fall within one standard deviation of the
mean, 95.45 percent fall within two standard deviations of the mean, and 99.73 percent fall within three
standard deviations of the mean.

When the problem is to estimate the mean number of losses in a "population" using sample
information, the concept of confidence intervals is useful. The risk manager can select the degree of
confidence he wishes in making such estimates. If certain statistical conditions are met in selecting the
sample, the risk manager may behave as if the mean number of losses occurring in the sample
represents the true mean number of losses in the total population, within a given error r ange and with
a given probability; of being correct.

Thus, the risk manager may be able to state, "I can be 95.45 percent sure" that the population mean
number of losses will fall within the range of two standard errors from the sample mean. If the mean is
10 losses and the standard error is 1.02 losses, this means that the risk analyst can predict that the
population mean number of losses will be within the range of 10 plus or minus 2 (1.02) or between 7.96
and 12.04. The probability that he will be right is .95.

Expected Value. One of the most useful statistical concepts in risk management is that of expected
value, the result obtained by multiplying the value of each possible event times its respective probability
and then summing. For example, assume there are only two possible events, "fire" and "no fire" with
corresponding probabilities of .01 and .99, respectively. Assume that if fire occurs the loss is $10,000,
but if no fire occurs the loss is zero. The expected value of loss by fire is $10,000(.01} + $0(.99) = $100.
The expected value is the mean of the above probability distribution. It expresses the average long-run
loss which an insurer would have to pay if it insured this event, and thus summarizes the "pure
premium" calculation which is the starting point for determining the final premium.

Rules of Probability Analysis

There are certain basic underlying assumptions of probability analysis which should be observed if
sampling technique is to be successfully employed in loss prediction.

1. The sample (or set) from which conclusions are drawn must be randomly selected from the larger
population comprising the universe of all possible events. If this requirement is not met, in the case
of the simple random sample, for example, not all the items have an equal chance of being drawn
and generalizations about the larger population of events will not necessarily be true.

2. All weights assigned to probability statements must be positive. Probability is so defined that it
cannot be a negative number. Rather, probability is expressed as a number between 0 and 1.
Probabilities assigned to a set of mutually exclusive and collectively exhaustive events must total to
1. Events are mutually exclusive when there is no possibility that if one event occurs, the other can
also occur. A set of events is collectively exhaustive if it represents all possible events in the set. We
will illustrate this situation below.

3. If events in the sample occur independently of one another and are randomly selected, certain
calculations become possible which are of great value in risk management and decision making.
Events are said to occur independently of one another if the outcome in one event does not affect
the probability of occurrence of another event. Thus, if it may be assumed that because a fire has
occurred once, there is no necessary change in the probability of having a second (or third) fire, we
can say that fire losses are independent of one another.

4. If we know the probability of an independent even tin a set of mutually exclusive and collectively
exhaustive events, we may employ certain rules such as the additive and compound probability
rules. Under the additive rule, for example, if the probability of occurrence of four events in such a
set is .25 for each event, the probability of occurrence of either of two events is .50, (.25 + 25); any
three events, .75; and any four events, 1.0. Thus, the probability assigned to all the events must
total to 1. The compound probability rule states that the probability of simultaneous or consecutive
occurrence of two or more events in a set of mutually exclusive and collectively, exhaustive events is
the product of their individual probabilities. For example, assume there are two decks of well-mixed
cards and we wish to know the probability of drawing an ace from each deck on the first draw. The
events would be independent of each other since drawing an ace from one deck would not
influence the probability of drawing an ace from the second deck. The probability of this occurrence
 would be the product of the separate probabilities, or 4/52 X 4/52 = 16/2704, However, if we draw
two cards from one deck only and we obtain an ace on the first draw, the event "draw an ace on the
second draw" is not independent of the first, since there ate now only 51 cards left to draw from.
Accordingly, the probability of drawing two aces from the same deck would be 4/52 x 3/51, or
12/2652. This second example is an example of conditional probability. The probabilities of all
possible events in this example must total to 1.0, as shown in Table 3-1.

5. Conditional probability is the probability of some event, given the occurrence of some other event or
some combination of events. The event in question is no longer independent, but depends on some
prior condition being fulfilled. For example, assume that there are four possible events with the
probability given in Table 3-2.

Assume that we wish to know what the probability of two or more collisions will be, if there are any
collisions at all. By the additive rule, we know that the probability of two or more collisions is .10 (the
sum of probabilities of events 3and 4). However, we are redefining events and are imposing a limitation
that involves only a part of the sample set by the conditions set forth. This part is restricted to the sum
of the probabilities involving any collision (the sum of events 2, 3, and 4). These probabilities total .30.
The denominator of the probability equation is therefore .30, and the conditional probability is the ratio
.10/.30, or 1/3, that if there are any collisions at all, the probability of two or more collisions is one in
three.

Probability

Event 1st Draw 2nd Draw

Draw two aces 4/5 x 3/51 12/2652

Draw no aces 48/52 x 47/51 2256/2652

Draw one ace only,

1st draw

Draw one ace only, 4/52 x 48/51 192/2651

2nd draw

48/52 x 4/51 192 / 2652

1
2652 / 2652

Table 3-2

Event Probability

1. No collisions occur in one year .70

2. On collision occurs .20

 3. Two collision occurs. .06

4. three or more collisions occur .04

TOTAL 1.00

In symbols,

.10
P(E1) given E2 = P(E1) = .30

P(E2)

where E[ is the event two or more collisions will occur (sum of 3 and 4 above), and E2 is the event one or
more collisions will occur (sum of 2, 3, and 4 above).

APPLYING PROBABILITY RULES

The above rules of probability analysis must be used with care because in actual practice the
assumptions on which these rules are based may not be met, or may be met only approximately. Often
one of the principal weaknesses of data available to the risk manager is that the data may not be truly
representative of the larger population from which they are drawn and thus may lead to inaccurate
conclusions. For example, a risk manager may observe accidents in a plant over a period of five years
and calculate the mean and standard deviation of losses. From this he reasons that the best single
estimate of loss for the next year is the average of the past five years. How might this be misleading?
Lack of representativeness may be due to several factors; (1) the sample may not be large enough; (2)
the sample may be biased; (3) the sample may not have been drawn at random; or (4) the events may
not be independent of one another. In other words, there may be large sampling error which should be
recognized in interpreting the results. Sampling error might be caused by generalizing from a sample
which is too small and hence unstable. (The number of losses may vary 100 percent from year to year.)
The sample may be drawn from a single month, such as January, or from a single plant, neither of which
may be a typical month for accidents or a typical plant for working conditions. In some plants losses may
be unusually high because they are not independent; e.g., unsafe acts of some workers may be copied
by other workers in the plant. Accident frequency may increase over time as long as this condition
exists.

The firm may utilize sources other than its own records in order to increase the accuracy of estimates of
probability and variation of losses. Insurance industry records, trade association data, and governmental
studies are among the sources which might be utilized.

In the absence of objective data on which to base estimates of probability and variance of losses,
subjective estimates can be made, based on prior general experience of managers.

Another basic rule of probability, the central limit theorem, may be utilized to forecast losses by
statistical means.
Forecasting Losses by Statistics.

In most risk management problems involving loss estimation, it is not practical to take a large number of
samples. Sampling experiments have shown that when a number of random samples are taken from a
population, the mean of each sample will vary from the mean of the population. However, if the number
of samples taken is large enough, and the sample means are plotted on graph paper, a normal curve of
error will result, i.e., it will be bell shaped. This happens even if the data in the original population or
from a single sample are not distributed normally. This result has been proved mathematically and is the
essence of the central limit theorem, of which the law of large numbers is a special case.

Standard Error.

The standard deviation of these sample means has a special name, standard error. The standard error is
used to draw inferences about the universe. These inferences include: (1) the mean of the random
samples approaches the mean value of the population from which they are drawn when the number of
samples is large enough; (2) one standard error includes 68.25 percent, two standard errors include
95.45 percent, and three standard errors, 99.73 percent of the area under a normal curve. The formula
for standard error is

s
SE = n

where n is the sample size and s is the assumed standard deviation of the population. Let us illustrate
the use of standard error in the following risk management problem: A risk manager observes a sample
of loss data (see below) from a sample of 1,000 workers (n) in one year, and he wishes to draw
inferences about future losses which might be expected over a large number of years. He calculates the
mean (M) and the standard deviation (s) of losses in the sample. The risk manager does not know what
M and s are for the whole "population," but the mean and standard deviation of his sample are the best
single estimate of the mean and standard deviation of all losses in the population—i.e., all losses to be
expected in a large number of years in the future. What variation in losses can be expected in all future
years? To answer this question, the risk manager first calculates the standard error, by the above
formula. The steps are as follows:

Step 1. Calculation of the mean of losses in the sample is:

Dollars of Loss X Number of workers n Total loss

0 800 0

110 100 11000

200 70 14000

500 30 15000

1000 $40000

Mean loss (M) $40

Calculation of the standard deviation of this sample is:

X-M (X-M)2 n Weighted squared

deviation

-40 16000x 800 1280000

70 4900x 100 490000

160 25600 70 1792000

460 211600x 30 6348000

Total 1000 9910000

Mean squared deviation $9,910 Standard deviation = 9910  $99.55

Step 2 Calculate the standard error (SE)

s $99.55 99.55
   $3.15
SE = n 1000 31.62

Note that although the standard deviation ($99.55) is relatively large, when compared to the mean loss
(S40) the standard error ($3.15) is quite small.

The risk analyst can assume in the above case that for all possible future periods, the mean loss will lie
within a known range of $40. Specifically, the risk analyst can be 95.45 percent confident that the mean
loss will fall in the range $40 ± 6.30 (two standard errors). At the 99.73 percent confidence level, the
mean loss will fall within the range $40 ± $9,45 (three standard errors). Note that in this calculation the
risk analyst may draw inferences only about the mean loss for a large number of years. The mean loss
for the next year of any single year may have a greater variation than that shown above. Thus, in the
above example the distribution of losses from 1,000 workers in a single year could look very differently
from the above.

Setting Loss Reserves. Using the above analysis and knowing that the firm has 1,000 workers, the risk
analyst may predict that the average annual losses will not exceed $49.45 x 1,000, or $49,450, 99.73
percent of the time. Using this information, the risk manager can estimate the size of a loss reserve fund
in the event he plans to recommend self-insurance for the risk. In this case, he might recommend a self-
insurance fund of $50,000,; even though the best estimate of losses for any one year is $40,000.
Rate Negotiation. The risk manager may also use the above analysis in his negotiations with commercial
insurers on premium rates, The pure premium, or expected value of the loss, is $40; the relative risk (at
the 99.73 percent confidence level) is $9.45/540, or 24 percent. If the insurer requires an expense
loading of 35 percent, the gross premium should approximate $40/(1 - .35), or $61.54. plus whatever
charge for risk the insurer might make. Because the risk manager can demonstrate that there is little
chance that in the long run the pure premium will exceed the expected by mote than $9,45 per worker,
the final premium quoted per worker should not exceed

$40.00  $9.45
or $76.08
1  .35

Some insurers may quote less than this amount because their aversion toward risk may be less than
other insurers. (Measurement of subjective risk attitudes is discussed below.)

TOPIC TEN

RISK MANAGEMENT TECHNIQUES

INTRODUCTION: In our previous discussion we looked at risk measurement. Once risks have been
identified and measured in terms of their probability of occurrence and the magnitude of the magnitude
of the losses that each one of them could cause. These two factors provide a basis for classifying and
prioritizing the risks. Once this has been done, the next step is to determine how each of the risks
identified will be dealt with. This topic provides a guide on some of the methods or techniques that
could be used in handling the risks.

RISK RETENTION
A firm exposed risk usually has two alternatives to deal with the risk. One alternative is to transfer the
risk or its consequences to commercial insurers and other third parties. The other alternative is to deal
with the risk internally. When a firm decides to deal with a risk internally, it is called risk retention.
There are two forms of risk retention.

(i) Risk retention can take the form of a simple assumption or acceptance of the risk. This is a form of
non-insurance. It means that the risk and its consequences are ignored. No financial arrangements or
plans are made at all to deal with either the risk or its consequences. If a risk has a very limited chance
of occurring and its impact on the firm is negligible even if it occurs, then simple assumption or
acceptance becomes a viable option to consider. But if its impact is significant then this option may not
be a viable one.

(ii) Risk retention can also be in the form of self-insurance. Self-insurance normally involves a definite
plan put in place to meet losses arising from a particular risk or group of risks. This option makes sense
if the potential losses from the risk are large enough to cause financial embarrassments or even
insolvency. This makes it necessary to have a financial plan to handle the consequences of the risk. This
may be done through a formal special reserve fund or a loss fund.

Risk retention can be achieved in the following ways:

(a) Bearing all the losses from a given source

(b) Bearing the losses up to a certain amount and purchasing commercial insurance on
excess

(c) Establishing loss funds either before or after the occurrence of loss

(d) Establishing a captive insurer

(e) Using retrospective rating.

Since nothing is done in simple assumption we can concentrate our attention in examining self-
insurance in detail.

OBJECTIVES OF SELF-INSURANCE

1. To reduce the cost of handling risk to reduce the amount of capital tied up in reserves. This assumes
that the firm can handle the functions normally carried out by a commercial insurer more effectively
and efficiently through its own organization than through the insurer. Other financial gains include
avoidance of insurance commissions and earning interest on funds otherwise paid to a commercial
insurer for losses and expenses which need not be paid out immediately.
2. Another reason for self-insurance is to obtain greater flexibility in handling risk. Commercial
insurance often have more or less rigid underwriting rules which restricts the firm’s freedom of
action in various ways a self insurance plan may enable the firm to handle all types of risks
simultaneously.

3. A third objective of self-insurance is to improve loss-control. This may come about because the firm
has greater incentives to reduce losses since an outside party, such a commercial insurer, will not be
standing the losses from lax attention to loss prevention activities.

4. A fourth objective is the improvement of claims handling. The firm with it’s own fund can settle
claims without the delays which are often involved when an outside party is involved in making
independent investigations of the loss.

5. A fifth objective is to improve the quality of services, which would otherwise be provided by the
insurer. In many kinds of situations, the charges of insurers for services such as loss prevention,
replacement of property, and loss adjustments are substantial, but the quality of these services may
be uncertain. The individual firm may decide that it can provide such services more effectively and
at less cost.

6. Finally self-insurance may be the only alternative to a firm who finds it impossible to use commercial
insurance because of either high cost or unavailability of a commercial insurer for that type of risk.

FACTORS FAVOURING SELF INSURANCE

1. The risk of loss should involve a sufficiently large homogenous set of objects, so situated that
average losses become predictable within reasonably narrow limits. Records permitting a prior
estimate of probable loss should be available. Property should be dispersed geographically so that it
is not subject to simultaneous destruction by a single peril.

2. The firm should have sufficient financial strength to either set aside self-insurance funds to meet
expected losses, or to meet these losses from working capital without financial embarrassments.
This suggests that the type of exposure to be self-insured will involve objects of relatively low
financial value, so situated that catastrophic losses to a large segment of such objects are not
possible.

3. The firm must be willing to undertake the administrative requirements of a self-insurance plan.
These include investing self-insurance funds, keeping of adequate records, administration of claims,
loss prevention work and analysis of loss exposures. The administration of a self-insurance plan is
similar to the administration which would be done by the commercial insurer, and the firm
undertaking it should recorgnise the technical problems which this involves.

THE ECONOMICS OF SELF INSURANCE

1. It may be observed that a self-insurer would not have to pay expenses such as taxes, fees,
commissions and brokerage, and other acquisition costs.

2. The amount saved on expenses might be significant if not out weighed by other factors in the self-
insurance decision.

3. Loss reduction may be effected more efficiently under self-insurance programs than under
commercial insurance arrangements. Incentives for loss control may be greater under self insurance
because the self insurer is rewarded immediately for loss reduction and does not have to wait for
the commercial insurer to recognize reduction in lower rates, higher dividends, greater services, or
some combination of these. Better loss control may have indirect rewards through better employee
relations, improved morale, and greater production efficiency.

4. The amount of reserves that should be set aside in self-insurance funds may often be less than the
reserves required by a commercial insurer. Some insurers have been accused of over reserving and
building into the premium structure an amount considered excessive to the potential self-insurer.

LIMITATIONS OF SELF INSURANCE

1. Many firms will not meet the required conditions for a successful plan. For example there may be
too few homogeneous exposed objects to meet the requirements of predictability of losses,
inadequate financial resources to set up a self-insurance fund, and inability or unwillingness to
provide the necessary personnel to administer the plan satisfactorily.

2. The efficiency in administration of self-insurance plans may not equal or exceed that of the
commercial insurer. This is particularly likely to occur if the firm is too small to spread the fixed cost
of an insurance plan over a sufficiently large operating base.

3. The earnings available on the funds otherwise used for premiums to commercial insurers may not
be sufficient to justify the expense involved in setting up self-insurance plans. The opportunity cost
of funds used in self-insurance may be high.

4. Since tax laws and rulings change constantly, tax conditions may be such that self-insurance plans
are disadvantageous, or any tax advantage may be too small to offset the possibility of instability in
reportable profits.

5. The firm may lose catastrophic risk protection at acceptable premiums under self-insurance plans
because of lack of experience, skill, and economic power in dealing with reinsures.

6. The firm may not wish to lose certain services offered by commercial insurers, such as safety
inspections, investigation services in connection with fidelity bonds, and third party influence in
dealing with employee claimants under workers compensation. The firm may not be able
economically to replace services needed from commercial insurers.

7. The firm may face certain legal problems because of self-insurance plans.
8. When self insurance is applied to group life and health plans, administrative work may be
complicated due to the necessity of maintaining payment to sick or injured employees over a period
of years and to uncertainties as to the proper size of reserves for losses.

9. There is frequently a greater worry factor associated with self-insurance than with commercial
insurance.

LOSS CONTROL

INTRODUCTION

An important responsibility of the risk or insurance manager is that of leadership in the area of loss
prevention and control. Loss control itself is an activity which must be carried on throughout the
enterprise and on many different levels in the nation, state, and community. The risk manager is not
solely responsible for loss control leadership since this type of management must necessarily affect
most executives and supervisors throughout the firm. Yet, because loss control is so important in its
effect on the success of risk management, generally the risk manager must take a leading role in the
planning, organizing and controlling of activities that are directed at preventing or reducing losses

Concepts in Loss Control

Loss control may be defined as those activities designed to reduce, prevent or otherwise control
accidental events which produce economic or social loss. Loss control is aimed at reducing both the
frequency and the severity of losses.

Hazard Control
In understanding loss prevention it is important to identify the concepts of physical, moral, and morale
hazards. As defined in Chapter 2, a hazard is a condition which affects both the frequency and severity
of losses.

Recognizing that control over physical moral and morale hazard presents one approach to effective loss
control, risk managers have organized their activities around a hazard control framework. Thus sprinkle
systems may be installed to reduce the physical hazard of fire and driver training may be used to reduce
the morale and morale hazard to automobile accidents. Internal accounting control are employed to
reduce the moral and morale hazard leading to embezzlements.

The chain concept it is recognized that loss control may be viewed in a framework of a chain of events
leading to loss. Links in the chain are the source of loss, reduction of hazard, minimization of loss, and
salvage. Appropriate corrective action may be taken anywhere in the chain.

Source of loss

Hazard Reduction

Lost Minimization

Salvage

An illustration of controlling loss at its source is an effort to reduce fire damage in high rise construction.
The can minimize the economic loss that might otherwise result. The risk manager should consult with
architects on this problem in the very early stages of the project. Fire safety needs to be considered at
the design stage for maximum effectiveness, High – rise building present special problems in
extinguishing fires before they con spread, due to difficulties in applying fire-fighting techniques to
elevated locations.

Three major fire control problems need to be overcome in high-rise buildings. First- the building must be
provided with, appropriate cut-offs t o prevent the spread of fire through openings used for heating
flues electrical equipment, telephone systems, and the like. Second steel girders and other material
should be covered with fire-protective coating to prevent early collapse from heat. Third, the building
should be supplied with venting systems to dissipate heat, a source, of much damage in fires.

Human Vs Mechanical concept

One philosophy of loss control states that it is most productive to concentrate upon the human being in
preventing, avoiding, or reducing the consequences of loss. Another philosophy holds that it is best to
concentrate on the mechanical or engineering approach — to make the physical, social and
psychological environment in which the human being operates a safer environment,

To illustrate, the human approach to loss control would hold that to reduce industrial accidents it is best
to enforce safety rule, help prevent unsafe acts which lead to accidents, and to instill loss prevention
consciousness at all levels of management. The engineering approach would hold that is most effective
to concentrate on having safe mechanical conditions in a plant, such as good lighting, foolproof
equipments, good housekeeping, and machine guards.

Haddon's Energy Transfer Approach

William Haddon’s approach in analyzing the caused of loss offers an interesting risk management guide
to developing a formal strategy of loss control. Haddon draws attention to the fact that damages to
individual and property

Are essentially results of unplanned, often rapid releases of energy. Examples include hurricanes, fire,
lightning and vehicle.

Are essentially a result of unplanned, often rapid releases of energy. Examples include hurricanes, fire,
lightning, and vehicles. There are ten strategies in which this energy transfer process may be managed in
such a way to prevent or reduce the resulting damage.

It will be observed that Haddon’s energy transfer approach contains some of the elements of both the
chain concept and Heinrich approach discussed above. An important advantage of Haddon’s concept is
that is focuses on the ways in which a common element or force namely energy, may be dealt with, no
mater what the particular type of loss may be, thus the concept can be applied to fire, flood, earth –
quark, death, disability, and to many other perils which involve energy transfer causing loss to persons
or property.

Strategy Illustration

1. Prevent marshalling of energy in the first 1. Prevent workers from climbing lo high
place places from which they may fall.

2. Reduce the amount of energy which is
marshalled from which accidents may
result.
2. Reduce the number of workers permitted
to climb to high places.
3. Build guard rails to prevent falls from high
places.
 3. Prevent the release of energy which has
built up.
4. Slow down the release of energy,
5. Separate, in space or time, the energy
which is released from the object
susceptible to injury,
6. Place a physical barrier between energy
source and the object susceptible to
injury.
4. Reduce the height from which employees
must work; slow down the rate at which
explosives are permitted to burn.
5. Prohibit entry to blasting areas during
blasting periods.
6. Require workers to me- safely helmets,
shoes, or eyeglasses.
7. Design cars with padded dashes, build toy,
without sharp edges.

7. Modify the contact surface by rounding or 8. Require fireproof building construction,

softening edges, Require workers lo be vaccinated against
diseases.,
8. Strengthen the object against damage by
energy release, 9. Use fire alarm systems, sprinkler system,
emergency medical care facilities, storm-
9. Mitigate the damage which has not been
warning systems.
prevented by above eight measures,
10. Retrain injured workmen with permanent
10. Use rehabilitation and restorative
disabilities.
techniques where damage has occurred.

In applying the above strategies, Haddons points out that they need not be employed successive, but
rather as may many as possible should be applied all at once. A risk manager might be applied all at
started for example in a problem of dealing with the peril of fire in a warehouse where fuel supplies are
stored. Strategy could not be used unless it is decided not to store fuel on the premise at all but strategy
2 could be employed by reducing the amount of fuel, particularly hazardous fuel stored at any one place
or time. Strategy 3 would suggest that fore walls be built around fuel locations and strategy 4 might be
used by storing fuel in small containers so as to reduce the concentration of burning if a fire once
started. Strategy 5 would suggest that fuel depots be separated from other property to which fire might
spread and strategy 6 might result in protecting nearby properties with fire retardant or explosion –
proof barriers. Strategy 7 might have application in that storage tanks of floors could be padded so as to
reduce the chance of sparks which could ignite the fuel. Strategy 8 could result in having nearby building
or other property made out of fireproof materials and strategy 9 could suggest that the nearby
properties including the storage warehouse itself be protected by fire and sprinklers system. Finally
strategy 10 could be followed in case losses occurred by procedures involving adequate salvage
development of more efficient rebuilding techniques or utilization of better replacement materials.

Systems Safety

An approach lo loss control which has received increasing emphasis is known as systems safety under
this concept, a safety engineer conceives of a plant as a total system rather than concentrating on
specific loss exposure. Systems safety was first o developed by thee U.S Air Force as an engineering
discipline to assure the successful completion of weapon systems. Systems safely involves simultaneous
consideration of each working part of a plant such as factory layout lightening, noise, ventilation,
security, machinery design, and working rules.

Utilizing mathematical techniques, the interrelationships and consequence of possible product defects
can also be analyzed and predicted. In this way attention to loss control in a broad context is possible.
For example, using systems safety the risk manager can achieve better control over future legal liability
suits against the firm for defective products which may be attributed to negligent operations of the
plant than would be otherwise possible. It is apparent that the systems, safety approach utilizes both
human and engineering methods to help prevent loss.

Safety Sampling

SaA technique to monitor employee safety performance and to measure the effectiveness of loss
control management is know as safety sampling. Steps in safety sampling include: (1) Gather data by
month on the number of accidents or other evidence being used to measure the effectiveness, of a loss
control program. Assume that the intention is to reduce the number of accidents and that the
effectiveness of the program is to be measured by answering; the question. Are the numbers of accident
per month within ‘permissible’ limits? (2) Establish a level for permissible accidents assume that the
intention is to recognize that the some accidents are inevitable and that random fluctuation in the
number of accidents will occur. Management is concerned only when the accident level exceeds some
average plus some acceptable range to allow for random fluctuation. If accidents exceed this permissible
level, it is to be assumed that the fault is due either to employee care lessness or indifference to the loss
control program.

Set up action to be taken once the permissible level is exceeded. For example, it may be decided that
the first and second time this occurs; the supervisor will be called in for discussion and asked for an
explanation. The third time it occurs, the supervisor will be replaced. On the other hand, a reward
system for keeping accidents below the permissible level would also be established.

It is obvious that the calculation of permissible levels of accidents is crucial to safety sampling. The
calculation may assume a theoretical probability distribution which accidents tend to follow.

LEVEL OF APROACH

Loss control and prevention may be approached from several different levels in society (1) deferral
government (2) state and local government (3) private insurers and insurer –support associations (4)
firms and (5) individual

National government activities

Increasingly the government has concerned itself with the problem of safety and loss prevention.
Perhaps one of the most significant pieces of legislation passed in field is the 1970 occupational safety
and healthy act (OSHA) discussed in detail below. This act is sweeping in that it requires employers to
maintain a work place free from recognized hazards that can cause death or physical harm to
employees. It covers all business firms in interstate commerce except for mining and railroad industries,
which are covered by other federal safety laws and programs. Another federal agency under which loss
prevention is a major function is the food and Drug Administration which works to ward making safer
foods and drugs available.

County Government

Hundreds of state and local agencies carry on loss prevention work. To mention only a few there are
state and local police force, state fire marshal officers, local fire departments, and water and sewer
control agencies automobile accidents prevention agencies including statistical gathering groups),
industrial accident commissions, building inspector public health agencies and public school and
universities which teach safety training.

Private insurer Organizations

Many insurance companies and large agencies specialize in loss prevention work for their customers.
Prominent among these are insurers specializing in given lines of insurance, such as workers
compensation, multiple- peril policies on large risks, credits insurance, glass insurance surely bonding,
boilers and machinery insurance and health insurance.

Most large business firms sponsor active loss control programs. Among their activities are safety
inspections, maintenance of first- aid offices, drivers training, plant safety education and training, and
forecement of safety work rules, installation of safety equipment and devices, and design of machine
and production systems to prevent accidents.

Individuals

Loss prevention is also a responsibility of the individual who must cooperate in this endevour for the
entire effort to be successful. No mater how careful the design of a plant for safety, how thorough the
employee training in safe procedures how excellent the safety equipment provided or how meticulous
the safety supervision if the individual employee fails to practice that which he has taught the loss
prevention effort may fail.

LOSS CONTROL AND INSURANCE

As noted above, insurance organizations are very active in attempting to promote loss control work. Not
only is this effort accomplished through support of specialized organizations such as Underwriters
Laboratories, The National Safety Council, and the National Fire Protection Association, but other
methods are employed as well. Perhaps the chief ways in which insurers work towards loss prevention
other than specialized organizations are (1) policy provisions requiring loss prevention effort on the part
of the insured and (2) the rating structure for insurance

Policy Provisions

Most property and liability insurance contracts require the insured to pay attention to preventing his
own loss, once accident has occurs, to minimize the severity of loss. For example the basic conditions all
the fire insurance contracts suspended coverage (1) while the hazard is increased by any means within
the control of knowledge of the insured or (2) while the building is vacant or unoccupied beyond the
consecutive days. If a loss occurs, the insured is required to protect the property from further damage.
Most types of insurance payments where the injury or accident is caused deliberately by or at the
direction of the insured.

Rating Structure

Loss control is encouraged in many lines of insurance through granting of rate credits to the insured for
loss prevention effort. A prominent example of this is in the field of fire insurance. The rating system in
fire insurance is based on four major factors of construction exposure to loss type occupancy and the
rating class of the city in which the building is located. Lower rates are assigned to concrete and brick
construction than to frame construction, to properties containing nonflammables that to properties
containing flammables and to buildings contained in safe cities than to buildings in an area without fire
department protection.

The fire insurance rating structure contains an elaborate system of charges for such factors as
flammables shingles, nonstandard stairways or heating systems; poor housekeeping and the like credits
are given for loss preventions devices such as sprinkler systems, alarm system, and properly located fire
walls. In this way the insured is given positive incentives for installing loss prevention measures and in
penalized through higher insurance rates for ignoring features which reduce either the frequency of
severity of loss.

Loss control and the government OSHA

The inspection made by compliance officers may be unannounced. Visits may be made at the request of
employees if they believe that an alledge violation of safety existence which threatens physical harm.
Employee representatives have the right to accompany an inspector during his physical examination of
the plant. If a violation is found a citation must be issued in writing and this citation must be
prominently posted by the employer near the place of the violation.
Specific standards for occupational safety and health are issued under the act. The standards may be
grouped under the headings (1) Industrial hygiene, (2) machine operations, (3) material handling, (4)
medical facilities, (5) personal protection, and [6) giant design and maintenance. Examples of standards
in each case are as follows:
1.
Under industrial hygiene, the standards set maximum levels of radiation, noise, temperatures
and pressure. Thus the workers may not be subjected to more than ninety decibels of noise in
each eight- hour day.

2. Standard covering machine operations specify among other things that dull saw blades must be
immediately removed, that bearings shall be kept free from lost motion and be well lubricated,
and that saws shall be sharpened and tensioned by qualified persons.

3. Material-handling specifications require, for example, that industrial-powered trucks must be

appropriate in size and power for the job they are expected to do, in accordance with detailed
specifications under eleven different classes of trucks. Appropriate safety guards, fuel handling
and storage, lighting, control of noxious gases, are specified. Drivers must receive acceptable
training before operating powered vehicles and the fifteen rules of driving are spelled out.

4. Medical facilities specifications require that workers receive prompt care for injuries, either
from personnel in a company-maintained infirmary, or from others who have been trained for
this purpose if an infirmary is not provided. Where the eyes or body of a worker are exposed to
injury from corrosive materials, suitable facilities for quick drenching or flushing of eyes or body
must be provided within the work area for immediate emergency use. Pre employment physical
examinations arc required under sonic conditions to sec if workers are qualified physically for
their jobs.

5. Specifications for personal protection include standards for protective devices for workers eyes
and face, respiratory tract, head, feet, hands, and ears, For example, the regulations state that
cotton stuffed in the ears will not be acceptable, but fine glass wool, earmuffs, wax-impregnated
cotton, or earplugs may be acceptable.

6. Where hazardous materials are involve specification also regulate plant design and maintenance
as It affects stairways, ladders, scaffolding, stands, towers, signs, and various working surfaces,
For example, rungs in ladders must be at least sixteen inches long. Accident prevention signs
and tags must be color-coded so that red will be used to mark fire protection equipment and
cans of inflammable liquids. Orange is to be used on equipment which may cut, crush, or shock
the worker. Other colors are specified for different uses.

Education and Training

The human factor is rarely absent from risk situations. Often carelessness, incompetence, or lack of
technical knowledge is either the primary or at least a contributor cause of a loss-producing event.
Likewise, the failure of an individual or group to respond in the correct way to a loss situation may
contribute to the size of the ensuing loss. Consequently, education and training has a major role to play
in less reduction programmed, and should embrace everyone employed by, or associated with the work
of, an organization at even stage of its production, distribution and affersales processes, whether it be
engaged in the manufacture and/or handling of goods, or the provision of services.

Management Education and Training

Risk control: The aim should be to create in management an awareness of the risks to which the
organization is exposed and of the ways in which they may be controlled. As noted in Lesson 2, the lead
in risk control must come from top management, and though only a few members of the top
management team will require a detailed technical knowledge of the various risks and hazards, all
should understand and have a commitment to the principle of total risk control. Also, the organizational
structure and the division of responsibilities should be geared as far x^ possible to the same end.

15. At The planning stage: The need fur risk control should be recognized from the initial planning stage
of a new project right through to the final delivery and after- sales servicing of products. Management
education should cover not merely obvious matters such as employee safety but also the need to build
safety into their plan; and product designs. Planning for product, safety becomes increasingly important
as consumer awareness and claims for product defects increase. In the case of obviously potentially
dangerous goods and services, safety calls for top priority: Weber for example, recommends that the
design departments of motor vehicle manufacturers should include a team of engineers charged solely
with the task of minimizing the risk of product defects (Risk management in product liability, in Hand
book: of risk management).

Likewise, safety needs to be assigned a top priority during the design stage of say, aircraft, civil
engineering projects like bridges and dams and the development of new drugs.

Attention to risk control during the design stages of projects can be equally rewarding in less dramatic
ways. For example, by incorporating fire- resistant materials and the separation of hazardous production
and storage areas into the original plans for a new factory, a reduction in the fire risk can be achieved at
a fraction of the cost, including possibly the disruption of production, involved in making alterations
after the plant is operating.

At the production stags: The two groups of risks requiring attention at the production stage are
accidents causing injury to persons and/or damage to property, and the risk of producing faulty products
owing to reasons other than design defects.

The statistics published by the Health and Safety Executive show that the majority of injuries sustained
at work are due to falling or lifting and require no great technical knowledge to prevent. Likewise, the
origins of many fires lie in simple hazards, such as smoking, faulty electrical wiring, accumulations of
waste materials such as oily rags, and so on. Therefore, there is needed a commitment by management
to good housekeeping and regular maintenance of premises and plant in all departments. Essentially,
good housekeeping means keeping premises and plant clean, tidy, and well-maintained, and properly
guarding hazardous machinery and materials. It is the task of management to provide the necessary
cleaning and maintenance resources, to draw up rules, and to agree their enforcement with employees’
representatives. Good house -keeping achieves more than improved safety: it can also improve the
morale of a work force and reduce losses from wastage and spoilt work.

The prevention of major hazards usually calls for the use of technical knowledge, which if not available
within the organization should be bought in from consultants. Even a well-designed plant can be
operated in a dangerous fashion, possibly because of inadequate attention to maintenance or the
introduction of a foreign material into a process. Top management should make it clear to ail superiors
that the safety standards and rules that have been laid down for the operation of a plant must not be
waived, even temporarily, in order to maintain production.

The elimination of product defects during manufacture falls within the role of quality control. The more
vital is a product or a component to the safety of users or other persons, the more rigorous should be
the system of quality control employed. The continuous testing of products can be very costly,
particularly when it involves destructive testing, so that the methods and standards of testing employed
are decisions for top management. However, unless the highest technical standards available for
particular products are used, a firm will have little defence against claims arising from product defects.

After-sales usage and servicing: The need for safety procedures and rules does not finish with
production. Goods need to be delivered safely to customers in good condition and properly labelled,
with clear instructions for use and without imperiling others during delivery. In some cases after-sales
servicing will be required too. Therefore transport and servicing managers should be included in the
management education programme. They will need to know of any particular hazards associated with
the carriage, use and servicing of the product. Moreover, it is desirable that there should be some
system whereby information regarding defects revealed during after-sales servicing is fed back to the
design and production departments.

Security: Risk control is not merealy a matter of dealing with risks that may result in injury to persons or
loss of or damage to property. There are other risks that also may jeopardize the existence of an
organization and therefore need to be brought to the attention of management. The three notable
examples are defalcation, industrial espionage, and credit risks.

In all three cases the key to risk control lies in the laying down and enforcement of security procedures
by management. The increasing use of computers for accounting, design, and other purposes has
probably increased the protential for large scale losses owing to the dishonesty of employees or other
persons, and so attention needs to be given to computer security covering both the integrity and
security of programmes and records. The procedures should cover the ways in which jobs are to be
performed and systems of check.
Contingency Planning

Finally, management awareness of risk should lead on to the preparation of contingency plans for
coping with actual or potentiality severe loss situations. Such plans should embrace both salvaging
operations and plans for carrying on the business of the organization, following the occurrence of a loss.

The success of salvaging operations (and under this heading would fall the minimization of both
personal injuries and property damage) depends upon there being available at all times both a number
of people trained to deal with emergencies, and the necessary equipment. There is little point, for
example, in having available first aid. boxes, or the equipment and supplies for stripping down and
cleaning smoke or water damaged machinery, if no one knows what to do - and vice versa.

The severity of interruption losses is not necessarily directly proportional to the severity of the property
damage. There are many recorded instances of relatively small property losses resulting in prolonged
stoppages of production. Therefore in preparing a contingency plan to deal with interruptions to the
organization’s business, the first steps should be identify;

- All potential sources of loss-producing events which may disrupt operations;

- Interdependences between different pans of organization itself; for example, would damage to
one process or storage area disrupt all production of one or more of a firm’s products?

- Dependencies upon individual suppliers or customers;

- Alternative sources of supply or outlets, where any of the above dependencies exist.

It may be feasible to make some changes immediately that could reduce the potential impact on the
business of any incident, such as the duplication of key items of plant or power supplies. Likewise, by
holding larger stocks of raw materials and parts, (perhaps distributed between two or more buildings),
or by finding another supplier, it may re possible to reduce the vulnerability of the business to a
breakdown in supplies from a sole supplier. In all of the foregoing cases management would have to
decide whether the extra costs involved were a reasonable price to pay for the reduction in risk.

The actual contingency plan would deal with proposed responses to loss situations. It would set out the
steps to be followed under various circumstances and assign responsibilities for various tasks. Some
things may need to be arranged well in advance of a loss occurring; for example, mutual assistance
arrangements may be made with competitors whereby if one suffers a major loss of production
facilities, other will assist in the manufacture of its pro-duct(s).

Ensuring that people know what they are supposed to do will help to minimize losses, in that delays, and
possibly conflicting actions by different people, should be avoided. Radcliffe, for example, emphasizes
the importance of having plans for handling the risks of kidnap and ransom (‘Political risk management’,
Foresight, vol. IV, no 10). Criminals rely for success on surprise and the unreadiness of victims, families,
and employers. Therefore, potential victims and their families should know what to do if such an event
occurs. The plant should specify which members of the management team are to be notified, who will
be responsible for lulling the police, calling in a consultant for handling negotiations with the
kidnapper(s), helping the victim's family and making decisions during the course of those negotiations.

The Training of Employees

There are several fundamentals in the training of employees, notably:

- They need to be aware of the hazards to which they may be exposed in the course of their work
and what steps they can take to minimize the risk of injury to themselves and fellow employees;

- Training may be required regarding the use of special clothing and equipment provided for their
safety;

- Instruction for all employees as to what to do in emergencies, for example, upon the outbreak
of fire, breakdown of plant, and especially the breakdown of safety devices;

- Training of some employees to deal with emergencies until expert help arrives, for example, the
training of first-aid and fire fighting teams;

- Instilling a sense of safety - consciousness in all employees, both in relation to the way they
carry out their work and in the avoidance of defects in the firm’s products. The aim should be to
instil in each employee a sense of responsibility towards fellow-employees, customers and the
general public.

Education and Training of Contractors, Suppliers, retailers and Servicing Agents

Frequently the integrity of an organization’s operations can be jeopardized by people other than its own
employees, notably:

- Sub-contractors who undertake work an its behalf;

- Suppliers of components;

- Contractors who may perform work on its premises and plant.

For example, training schemes may be provided for servicing agents and their employees. Besides
providing technical training in the after-sales servicing of the principal's products, instruction may also
be given about the nature of any special hazards associated with those products, and steps to be taken
to report and remedy any potential defects. Suppliers of components that may affect the safety of the
completed product likewise can be made aware of the potential consequences of supplying faulty parts
and, perhaps, quality control systems and standards can be mutually agreed with them. Finally, anyone
comes to work on a firm’s premises, particularly if they may bring hazardous materials or equipment on
to the site, should be informed about major risks and any special hazards in the vicinity of where they
may be working.

Procedural Devices
Procedural devices to reduce risks are closely associated with, and have largely beer, covered by the
above sections on education and training. Therefore, it is sufficient to add that it is responsibility of
management:

- To devise procedures to reduce both the probabilities of loss-producing events occurring and
the severity of those events that do happen;

- To ensure that employees are not only trained to carry out those procedures, but that
instructions are observed;

- To instruct other people coming on to sites under their control, or involved in handling their
products, in safety procedures.

Physical Devices

There is a wide range of physical devices available to reduce the probabilities and/or severities of many
types of risk. They may be thought of as falling into two broad categories:

- Active devices which continuously operate to reduce the probability of the loss-producing event
occurring;

- Passive devices which come into operation when a particular situation arises.

Into the first category fall such devices as thermostats on boilers and refrigerating equipment, guards on
power presses and other hazardous machinery, overload switches on electrical equipment, and security
locks and window bars. Passive devices include security and fire alarms, sprinkler installations,
automatic fire doors and vents.

Summary

Doherty usefully summarizes the three approaches to risk reduction in the following table (‘Risk
reduction through loss prevention’, in Handbook of risk management.

Table 7/1. Devices to reduce risk

 Physical devices Procedural devices Educational and training

1. Pre- 1. Venting of toxic and 1. Maintenance and 1 Course in security, fire

conditions explosive fumes servicing prevention, safety and first
loss aid for all staff
2. Separation of on 2. Security check on
employees mutually employee and visitor 2 Specialist course for key
hazardous processes staff
3. House keeping
3. Segregation of 3 Education of management
4. Periodic review of
hazardous processes on productivity of security
safety conditions and
into less vulnerable
procedures
areas

2. Prevention 4 Automatic switch off 1 Procedure for 1 Clear instructions for

of loss devices for immediate noti- notification of faults.
machines if faults fication and
develop. inspection of faults to
ascertain if any
5 Safety guards for
hazard exists.
hazardous machi-
nery and plant.

6 Security locks, bars

and catches on
windows.

7 Overload and other

devices.

8 Safety valves for

pressure vessels.

3. Early 1. Fire and burglary 1. Security patrols,

discover; alarms with con- including night
nection to police watchmen. Inspection
4. of loss
and fire stations. of premises before
closure for evening or
2. Warning devices for
weekend. Internal
leakage of liquids,
audit sys-terms to
gases and
check embezzlement.
radioactive
materials.

5. Limitation of 1. Sprinkler, CO2 and 1 Appointment of first 1. Well-rehearsed evacuation

loss drencher systems. aid officers-internal procedure.
fire brigade.
2. Manual fire appli- 2. Clear instruction from
ances. notification of fire
 3. Internal locks. 2 Stand by equipment, brigade/police/ambulance
stocks and alternative and also for internal safety
4. First aid and
sources of power and security officers.
salvaging
services.
equipment.

5. Party walls.

The Health and Safety at Work, etc. Act 1974

In Britain, parliamentary intervention in working conditions dates back over a century, culminating in
the Health and Safety at Work, etc. Act, 1974 which embraces much of the earlier safety legislation, such
as the Factories Act 1961, Mines and Quarries Acts 1954-1971, Offices, Shops and Railway Premises Act
1963 and the Explosives Acts 1875-1923.

The main aim of the Act is to require employers (and the self-employed) to took at the conduct of their
undertakings as a whole to ensure that the safety both of their employees and of the public at large is
not adversely affected by their activities. Responsibility for safety, however, was extended by the Act to
include:

- employees, who are required to take reasonable care to avoid injury to themselves, to fellow-
employees and to others in the course of their work, and to co-operate with their employers
and other persons in meeting statutory requirements; and

- Designers, manufacturers, installers, erectors, importers, or suppliers of articles and substances

for use at work, who are required to ensure that, in so far as they are responsible, risks to health
and safety are eliminated, and that articles or substances are safe when properly used.

Employers are required not only to maintain safe plant, systems of work and premises (which includes
complying with all relevant regulations dealing with such matters as the guarding of dangerous
machinery), but also:

- To provide adequate instruction, training, and supervision;

- To prepare written company safety policies and to make them known to all employees;
 - To allow recognized trade unions to appoint safety representatives at each work place. Safety
representatives have the right to investigate potential hazards, carry out inspections of the work
place atleast every three months or following notifiable accidents, occurrences and diseases;
consult with and receive information from Health and Safety Executive inspectors, and so forth.
Two or more safety representatives may request an employer in writing to establish a safety
committee within three months.

The operation of the Act is entrusted to the Health and Safety Commission, with a full-time Health and
Safety Executive (HSE) being responsible for the appointment of inspectors to carry out the inspection of
premises and sites, and the investigation of notifiable accidents. If an inspection or investigation reveals
any failure to comply with the provisions of the Act, the HSE is empowered to issue either an
‘improvement notice’ requiring certain things to be done, or a ‘prohibition notice’ where there is an
imminent danger of serious personal injury. The HSE can also destroy articles and substances
occasioning imminent danger of serious personal injury.

Thus the penalties that may be imposed on a company for non-compliance with statutory requirements
can be severe. Moreover, the Act provides for the prosecution of any person in a supervisory position
who may have some responsibility for an accident which results in personal injury. Consequently it is
essential that a risk manager, or whoever is responsible for safety, should familiarize himself with all of
the regulations covering the organization’s activities, and ensure that they are complied with.

Responsibilities for safe working conditions and practices extend from top management down to the
shop floor. As noted above, it is not sufficient for management merely to supply safety equipment and
clothing - it must take steps to ensure that it is used by employees. Likewise, safe working practices
must be enforced, and employees must be clearly warned of the penalties that will be imposed for
failure to comply with instructions: repeated acts of disobedience can be a justifiable reason for
dismissal. (See N. Selwyn, Reducing risk liability by use of the employment contract. Section 9.3 in
Handbook of risk management.

SAFETY

In each factory, every moving part of a prime mover, fly wheel, whether they are in engine room or not,
stock bar, motor, rotory converter and dangerous part of any other machinery should be securely
fenced by safeguards, when they are in motion or in use. (Sec.21)

Examination of the above referred to machinery when in motion can be carried out only by a specially
trained adult male worker, wearing tight fitting clothing and whose names are recorded in the
prescribed register. (Sec.22)

Lifts and hoists should be of good mechanical construction, and of sound material etc., and should be
examined by the specially trained person at least once in six months and register for the same is to be
maintained in Form No. 11 (Sec. 28, Rule 62).
Examination of lifting machine, chains, ropes and lifting tackles should be done by a competent person
atleast once in six months and form no. 12 is to be maintained for the same. (Sec. 29, Rule 64).

53. If the manufacturing process involves risk of injury to the eyes from particles or fragments thrown
off or excessive light or exposure, the workers are to be provided with screens or suitable goggles for
protection of their eyes, e.g., dry grinding of metals by hand, welding or cutting of metals by electric
oxyacetylene etc. (Sec. 55, Rule 67).

Section 45 of Chapter V relates to provision of first aid boxes or cupboards with prescribed contents in
each factory, at least one for every 150 workers and this should be in-charge of a separate responsible
person trained in First Aid treatment and who is readily available during working hours.

Where more than 500 workers are employed, ambulance room of prescribed size with a medical
practitioner and, at least one qualified nurse etc., is to be provided,

RISK AVOIDANCE

This is the most drastic method of dealing with risks. While other methods are aimed at reducing the
profitability of loss or the severity of the potential impact and financial consequences of risks to which
an individual or organization is exposed, successful risk avoidance results in the total elimination of the
exposures due to a specific risk. The avoidance of risks involves abandoning of some activity, or
performing tasks in another way or at a different location. This means that one can avoid risks by
effecting changes in the nature of an organization’s activities e.g. changing production processes or
effecting changes in location of operations.

The main decisions are best taken during planning stages of a project because to make changes to an
existing operation willing most instances involve either major inconveniencies and/or disruptions to a
business or substantial expenses.

Therefore before any project is undertaken it should be subject to a full risk appraisal. It is cheaper to
avoid risk at this stage and it also more economical to build in many risk reduction devices during
construction than to modification later.

While it may be possible to undertake some avoidance of risk without undue difficulty or expense it is
never costless.
There maybe monetary costs such as additional bank charges for paying wages through banks in order
to avoid the risks of paying in cash or the opportunity cost as the income foregone by abandoning some
activity and so losing the benefits of the company.

RISK TRANSFER

Transfer of risks can take two forms:

a) Transfer of activity that creates risks (usually through sub-contracting)

b) The transfer of the financial losses arising from the occurrence of the risk (usually through
contract division)

a) Transfer of the activity

Transferring the activities has some advantages:

 The specialist may be able to carry out the job more safely, being more experienced and skilled
in that type of work.

 A further reduction in the risk may flow from the specialist’s ability to use equipment which the
principal may find uneconomical to utilize.

 The principle may avoid the difficulties and the bad publicity that an accident or even mere
carrying out the work itself may cause.

It must be clearly stated in the contract between the principal and the subcontractor that the
subcontractor will be responsible for any loss which may arise out of the work.

The responsibility will embrace any loss to the principal or any claim that be brought against the
principal by the third parties who may suffer injuries or damage arising either out of carrying out of the
work by the subcontractor or because of any defect in the work he has performed or part he has
produced which results in a defect final product or service supplied by the principal.

b) Transfer of financial losses

The transfer of the financial consequences of injury loss or damage from one party to a contract to
another party by means of clauses in the contract is a common practice in relation to liability arising out
of:

a) The sale or supply of goods and services whereby liability may arise out of injury, loss or damage
caused by goods, negligent professional advice etc, infringements of patents copyright, the
replacement of defective goods, and losses due to unsuitable goods having been sold.

b) The sale renting or leasing of property

c) Contractors or other persons entering and/ or working upon premises where liabilities may arise
out of damage to the employer’s premises or injury to employees.
 d) Injuries to third parties or damage to their property claims of nuisance, interference with rights
of way, pollution, etc

These clauses come in the form of either exclusions clauses or indemnity clauses. To be effective such
clauses:

a) Have to form part of a legally binding contract

b) The party seeking to take advantage of the clause must have brought it to the attention and
obtained the agreement of the other party during the negotiations leading up to the contract.
Once contract terms have been agreed, one party cannot introduce fresh terms as an
afterthought. A cannot seek to transfer to B because that was what he had intended originally
but forgotten to say so

c) In accordance with the doctrine of privity of contract only the parties to a contract can be bound
by the indemnity and exclusion clauses. If A accepts to do certain work with B subject to the
clause in the contract that A shall accept liability for any damage to property or for any injury to
third parties arising out of performance of the work, that clause shall not prevent third party C
who suffers injuries due to A’s negligence from claiming against B. the only way in which B can
protect himself against such situation is when negotiating the contract to obtain A’s agreement
to

-indemnify him for any injury damage or loss arising out of its performance

-to insure against such liability

d) On many occasions both exclusions clauses i.e. clauses that relieve one party of liabilities that he
otherwise would incur towards the other and indemnity clauses i.e. clauses that but an
obligation on one party to indemnify the other party for losses or liabilities the latter may incur
arising out of the performance of the contract have been subject to close scrutiny and strict
interpretation by the courts. Even through exclusion and indemnity clauses may not be illegal,
the courts construe them strictly against the party seeking to take advantage of them,
particularly when that is in the stronger bargaining position.

Practical considerations

Before any decision is made to seek to transfer a risk to another person with whom there is a
contractual relationship some points need to be considered.

1) What certainty is there that the attempted transfer of liability will prove to be effective? Will the
contract terms be upheld by the courts?

The following matters are considered relevant to the reasonableness or otherwise of a particular
contract term the relative bargaining strengths of the two parties

 Whether the party upon whom the liability falls received any inducements to agree to it or could
have entered into a similar contract with other persons without having to accept such a term.
  Whether the party knew or ought to have known of the extent of the term e.g. if it was a normal
custom of the trade or if he had had previous dealings

 Whether it was reasonable to accept that it would be practicable to comply with some
conditions which if not fulfilled would permit the exclusion or restriction of any relevant liability.

 Whether the goods were manufactured processed or adapted to special order of the customer.

Even if one is confident of a positive answerer to these two questions, there remains the further
problem that if a major loss occurs the other party may not be in a financial position at that time to
provide a full indemnity.

In these cases where the risk manager organization is on the receiving end of exclusion or indemnity
clauses he should clear with insurers that they will accept responsibility for liabilities which otherwise
would not have fallen on the organization.

2. Costs. The cost of transferring is usually included in the contract price. It is essential to weigh the
cost of transferring against that of assuming the risk.