Chapter One (1) 1. Risk and Related Topics

RISK MANAGEMENT & INSURANCE
CHAPTER 01: RISK & RELATED TOPICS
CHAPTER ONE {1}

1. RISK AND RELATED TOPICS
Introduction
Dear student, in this unit we will define risk. While then we will differentiate risk from
uncertainty, probability, peril and hazards; and classify risks into different categories. Therefore,
when you work through this unit make sure that you are able to:
 Know the concept of risk and list some of its basic definitions,
 Identify the association between risk, uncertainty and probability,
 Describe and explain the causes and effect relationship between risk, peril, and
hazards, and
 Know the major classification of risk.
Dear student, the starting point of any material on risk management and insurance has to be the
understanding of the concept of risk itself. Let you answer the question here under before you go
deep into the chapter.
The word risk is certainly used in ever day conversation and seems to be well understood by
those using it. For instance, you use the word risk quite often in your daily life. You often hear
people saying this is risky; do not take any risk, etc. So, what is your understanding of the word
risk? What impression does it give you when somebody mentions the word to you?
To most people, risk implies some form of uncertainty about outcome in a given situation. That
is, the listener understands in a given situation there is uncertainty about the outcome will be
unfavorable. This is loose intuitive notion of risk, which implies a lack of knowledge about the
future and the possibility of some adverse consequence, is satisfactory for conversational usage.
But as a student of risk management and insurance, you do not need to stop with this simple
understanding of the word risk. Rather, you shall explore more concepts incorporated in it.
1.1. Definition of Risk

Due to imperfect knowledge about the future, our actions are likely to result in outcomes, which
are different from our expectations. This is something that is not desirable. Risk exists because
there is no perfect foresight about the future.
Because risk is undesirable and its consequences are, at times, damaging to individual,
businesses and the society as a whole, mankind is constantly developing its predictive ability
through the constant upgrading and refinement of its knowledge. The more mankind is knowle
dgeable about the future, the more certain it will be concerning future events. But, the
disappointing phenomenon is that perfect foresight about the future is something impossible.
Thus, risk becomes a fact of life that will remain side by side with the activities of mankind.
Every discipline has its own specialized terminology, which has very simple meanings in ever
day usage often take on different and complicated connotations when applied in a specialized
field. No comprehensive definition exists so far. It is defined in different forms by several
authors with some differences in the wordings used. The essence however is very similar. In
general, risk refers to exposure to adverse consequences.
There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians
and actuaries each have their own concept of risk. Risk management is still in its infancy as a
body of theory. As a result, we find many contradictory definitions of risk throughout the
literature dealing with this phenomenon from the risk management or an insurance point of view.
However, risk traditionally has been defined in terms of uncertainty. Based on this concept, risk
is defined as uncertainty concerning the occurrence of a loss. For example, the risk of being
killed in a car accident is present because uncertainty is present. The risk of lung cancer for
smokers is present because uncertainty is present. And the risk of flunking/failing a college
course is present because uncertainty is present.
Although risk is defined as uncertainty, employees in the insurance industry often use the term
risk to identify the property or life being insured. Thus, in the insurance industry, it is common
to hear statements such as “that driver is a poor risk” or “that building is an unacceptable
risk.”
The term risk used in different ways; the following are some definitions given by different
scholars and practitioners in the different fields:
 Risk is the chance of loss.
 Risk is the possibility of loss.
 Risk is uncertainty of loss.
 Risk is the exposure to adverse consequence
 Risk is the probability of any outcome different from the one expected.
 Doubt
 Worry
 Undesirable events
 Risk is a combination of hazards
Let’s see if some definition means approximately the same thing, or has a different connotation,
to decide the one which is relatively proper definition, and which, if any, is relatively suitable for
our purpose.
 Risk is the Chance of Loss

Many writers define risk as the ‘chance of loss’ what exactly is meant by this term chance of
loss? Webster defines “chance of loss” in two ways:
 As ‘a possibility or likelihood of something happening’ and
 As ‘… a degree of probability’
One defect in the definition of risk as the ‘chance of loss’ is that we cannot always be certain
which of these two meanings is intended. On the other hand, ‘chance of loss’ is often used to
indicate a degree of probability in a given situation, and many writers reject the definition of risk
as the ‘chance of loss’ because of the possible connotation of probability.
When used to indicate a degree of probability the ‘chance of loss’ is most frequently expressed
as a percentage or a fraction. In this context the chance of loss is simply the probability of loss.
It indicates the probable number and severity of loss out of a given number of exposures.
Example: if you are offered a prize for drawing a white ball out of a box that contains nine black
balls and one white ball, your chance of loss is 9/10 or 90%. Those writers argue that if ‘risk’
and ‘chance of loss’ (i.e. probability of loss) mean the same thing, the degree of risk and the
degree of probability should always be the same. Yet when the chance of loss (defined as the
probability of loss) is 100%, the loss is certain and there is no risk. Risk always has the
implication that outcome is how somehow in question. When the chance of loss (probability) is
either 100% or 0, the degree of risk is zero.
 Risk is the Possibility of Loss

Another way of defining risk is to say that it is simply the possibility of loss. Note that when we
define risk as the possibility of loss, no attention is given to the probability as long as it is not
zero or one. The term “possibility” means that the probability of event is between zero and one,
and the very notion of risk implies that the outcome is in question. This definition probably
comes closer to the notion of risk used in everyday conversation. However, it is rather loose
definition, and does not tend itself to quantitative analysis.
 Risk is the Uncertainty of Loss

Some writers have carried the relationship (risk and uncertainty) to its ultimate degree and
maintain the risk as uncertainty. Unfortunately, like the term “chance of loss” the term
uncertainty is ambiguous, it has several possible meanings.
A contribution of major significance in the area of risk theory as it relates to insurance was
provided by Irving Pfeffer in his insurance and Economic Theory, Pfeiffer draws a distinction
between risk and uncertainty. According to Pfeffer,
 Uncertainty is a state of mind relative to a specific situation. It is measured by degree
of belief.
 Risk is a combination of hazards and is measured by probability. Risk is state of real
world.
There are common elements in all definitions of risk: Indeterminacy and loss.
 Indeterminacy: the notion of indeterminate outcome is implicit in all definitions of risk;
the outcome must be in question. When risk is said to exist, there must be at least two
possible outcomes. If we know for certain that loss will occur there is no risk.
 Loss: at least one of the outcomes is undesirable. This may be a loss in the generally
accepted sense, in which something the individual posses are loss, or it may be a gain
smaller than the gain that was possible.
In general, the following are some important concepts you should note from the above
definitions and discussions.
 Risk is the reality of the real world, but not belief i.e. risk is an objective concept.
 Risk refers to uncertainty as to the loss.
 Risk becomes important if there is uncertainty as to the occurrence of the loss
 If we are certain there is no risk
 Under risky condition, the outcome is undesirable
 The degree of risk is inversely related to the ability to predict the future.
 The more the future is unpredictable and unmanageable, the greater will be the risk
 If the probability of the occurrence is 1 or 0, the degree of risk is zero
 If many outcomes are possible, the risk is not zero. The greater the variation, the greater
the risk.
1.2. Risk VS. Uncertainty

Certainty is lack of doubt. In Webster’s New Collegiate Dictionary, one meaning of the term
“certainty” is “a state of being free from doubt,” a definition will suit to the study of risk
management. The antonym of certainty is “uncertainty” which is “doubt about our ability to
predict the future outcome of current actions.” Clearly, the term “uncertainty describes a state
of mind. Uncertainty arises when an individual perceives that outcomes cannot be known
with certainty.”
Uncertainty is doubt about our ability to predict the future. Uncertainty arises when an
individual perceives risk. Uncertainty is a subjective concept, so it cannot be measured directly.
Since uncertainty is a state of mind, it varies across individuals.
For complex activities, such as participating in a business venture, some persons are very
cautious, others are more aggressive. Although risk aversion explains some of the reluctance to
participate, the level of risk perceived by individuals also plays a key role. The perceived level
of risk depends on information that an individual can use to evaluate the chance of outcomes
and, perhaps, on the individual’s ability to evaluate this information.
The level and type of information on the nature of a risky activity have an important effect on
uncertainty.
Level of Uncertainty Characteristics Examples

None (Certainty) Outcomes can be Physical laws, natural
predicted with precision. sciences.
Level 1 Outcomes are identified Games of chance, Cards,

(Objective Uncertainty) and probabilities are Dies.
known.
Level 2 Outcomes are identified Fire, automobile accident,

(Subjective but probabilities are many investments.
Uncertainty) unknown.
Space exploration, genetic
Outcomes are not fully research.
Level 3 identified and
probabilities are
unknown.
The level of uncertainty arising from a given type of risk can depend on the entity facing the risk;
for example, an insurer or a governmental entity may regard the risk of earthquake as being at
level 2, while the individual may regard the earthquake as being at level 3. This difference in
perspective may be a consequence of an ability to estimate the likelihood of outcomes.
In general, the following important concepts can be noted from the definition.
o Uncertainty is the doubt as to the occurrence of certain desired outcome.
o Uncertainty is the doubt that a person is aware of it or conscious as to the existence of

the risk which is state of mind.
o Risk is the possibility of adverse deviation from a desired outcome that is expected or
hoped for which is state of real world.
o Uncertainty exists when individual is aware of it. But risk exists when a person is aware
of it or not.
o Uncertainty depends upon the person’s estimated risk.
o Unlike probability and risk, we cannot measure uncertainty by a commonly accepted
yardstick/standard.
1.3. Risk & Probability

Probability is the chance of occurrence of particular event or it is the long run chance /possibility
of an occurrence. Probability varies between 0 and 1. If the probability of the outcome is 0, that
outcome will not occur. If the probability of the outcome is 1, that outcome will occur. The
closer the probability is to 1, the more likely it will occur.
Risk is a characteristics of the entire probability distribution, where as there is a separate

probability for each outcome.
Like risk, “probability” has both objective and subjective aspects.
i. Objective Probability:
Objective probability refers to the long-run relative frequency of an event based on the
assumptions of an infinite number of observations and of no change in the underlying
conditions. Objective probabilities can be determined in two ways. First, they can be
determined by deductive reasoning. These probabilities are called a priori probabilities. For
example: tossing a fair coin. Second, objective probabilities can be determined by inductive
reasoning, rather than by deduction. For example, the probability that a person age 21 will dies
before age 26 cannot be logically deduced. However, by a careful analysis of past mortality
experience, life insurers can estimate the probability of death on a five-year term life insurance
policy issued at age 21.
ii. Subjective Probability:

Subject probability is the individual’s personal estimate of chance of loss. Subjective probability
need not coincide with objective probability. For example, people who buy a lottery ticket on
their birthday may believe it is their lucky day and overestimate the chance of winning. A wide
variety of factors can influence subjective probability, including a person’s age, gender
intelligence, education, and the use of alcohol.
Probability distinguished from Risk:

Chance of loss can be distinguished from objective risk. Chance of loss is the probability that an
even that causes a loss will occur. Objective risk is the relative variation of actual loss from
expected loss. The chance of loss may be identical for two different groups but objective risk
may be quite different. For example, assume that a property insurer has 10,000 homes insured in
Adama and 10,000 homes insured in Hawassa and that the chance of loss in each city is 1%.
Thus, on average, 100 homes should burn annually in each city. However, if the annual variation
in losses ranges from 75 to 125 in Hawassa, but only from 90 to 110 in Adama, objective risk is
greater in Hawassa even though the chance of loss in both cities is the same.
1.4. Risk, Peril & Hazard

The terms peril and hazard should not be confused with the concept of risk discussed earlier. All
of them transmit bad taste or feeling.
 Peril: A Peril is a contingency, which may cause a loss. OR: it refers to the specific
cause of a loss. Peril is also called loss producing agent. It is the source of a specific loss.
Peril refers to prime source of specific loss. Most of time, it is beyond the control of
anyone involved in the situation. If your house burns because of a fire, the peril, or cause
of loss, is the fire. If your car is damaged in a collision with another car, collision is the
peril, or cause of loss. Common perils that cause property damage included fire,
lightning, windstorm, hail, tornadoes, earth quakes, theft and robbery.
 Hazard: A hazard, on the other hand is that the condition which creates or increases the
probability of a loss arising from a given peril.
For example, one of the perils that can cause loss to automobile is collusion. A condition that
makes the occurrence of collusions more likely is an icy street. The icy street is the hazard and
the collusion is the peril. It is possible to establish the following relationship.
Hazard Peril Risk
Note: this relationship is not always true: because sometimes it is possible for something to be
both a peril and hazard. For instance, sickness is a peril causing economic loss, but it also a
hazard that increases the chance of loss from the peril of premature death.
? Can you think of some example of peril and hazard?
There are four major types of hazards:
1. Physical hazard
2. Moral hazard
3. Morale hazard
4. Legal hazard
1) Physical Hazard:
o A physical hazard is a physical condition that increases the chance of loss.
o A physical hazard is a condition stemming from the physical characteristics of the
exposure (object) and that increases the probability and severity of loss from given
perils.
o Examples of physical hazards include icy roads that increase the chance of a car
accident, defective wiring in a building that increases the chance of fire, and location of
property, (near burglar area, flood area, earthquake area).
o Such hazards may or may not be within human control.
2) Moral Hazards:
 Moral hazard is dishonesty or character defects in an individual that increase the

frequency or severity of loss.
 It origins from the evil character of that insured person.
 Arise due to dishonest and fraudulent acts of individual. A dishonest person, in the
hope of collecting from the insurance company, may intentionally cause a loss, or
may exaggerate the amount of a loss.
 Examples of moral hazard include faking an accident to collect from an insurer,
submitting a fraudulent claim, inflating the amount of a claim, and intentionally
burning unsold merchandise that is insured.
3) Morale Hazard:
 Some insurance authors draw a subtle distinction between moral hazard and morale
hazard.
 Moral hazard refers to dishonest by an insured that increases the frequency or severity of
loss.
 Morale hazard is carelessness or indifference to a loss because of existence of
insurance. Some insureds are careless or indifferent to a loss because they have
insurance.
 Examples of morale hazard include leaving car keys in an unlocked car, which increase
the chance of theft; leaving a door unlocked that allows a robber to enter; and changing
lanes suddenly on a congested interstate highway without signaling. Careless acts like
these increase the chance of loss.
4) Legal Hazard:
 Legal hazard refers to characteristics of the legal system or regulatory environment that
increase the frequency or severity of losses.
 Examples include adverse jury verdicts or large damage awards in liability lawsuits,
statutes that require insurers to include coverage for certain benefits in health insurance
plans, such as coverage for alcoholism; and regulatory action by state insurance
departments that restrict the ability of insurers to withdraw from the state because of poor
underwriting results.
1.5. Classification of Risk

Risk can be classified into several distinct categories according to their cause, their economic
effect, or some other dimension.
1) Financial Vs Non Financial Risks

a. Financial risks are one where the loss occurred has some financial implication; or where
loss occurred can be measured in monetary terms. Examples of financial risks include:
 Credit risk
 Foreign exchange risk
 Commodity risk
 Interest risk
b. Non-financial risks: those risks which do not have or expressed in financial terms.
Example: Agony one feels following the death of a person, personal injury and etc.
2) Static and Dynamic Risks

This is classification of risk based on its degree of intensity and its predictability.
a. Dynamic Risks
 Are caused by perils which have national economic consequence, like inflation,
calamities, technology, political upheavals, etc.
 Originates/ resulting from changes in the overall economy such as price level
changes, changes in the consumer taste, income distribution, technological
changes, political changes and the like. They are less predictable and hence are not
usually covered by insurance policies.
 Risk type which its effect is felt widely, and its effect is more serious compared to
static risk.
b. Static risks
 Refers to those losses, which would occur even if there are no changes in the
overall economy. They are losses arising from causes other than changes in the
economy. Unlike dynamic risk, they are predictable and could be controlled to
some extent by taking loss prevention measures. Many of perils fall under this
category.
 These are risks connected with losses caused by the irregular action of the forces of
nature/flood, earthquake or the mistakes and misdeeds of human beings (moral and
morale hazards).
 are caused by perils which have no consequence on the national economy, like a
fire or theft or misappropriation.
Note:
o Static risks would be present in an unchanging economy. If we could hold consumer
taste, output and income and the level of technology constant, some individuals would
still suffer financial losses. These losses arise as a result of the perils of nature and the
dishonesty of other individuals.
o Dynamic risks benefit the society over the long run since they are the result of
adjustments to misallocation of resources.
o Unlike dynamic risk, static risks are not a source of gain to society. i.e. they usually
result in a loss to society. Static risks affect directly few individuals at most exhibit more
regularly over a specific period of time and are generally predictable.
o Static risk and dynamic risks are not independent; greater dynamic risks may increase
some type of static risks. E.g. Industrialization (technology) affects global weather
patterns.
o Dynamic risks are less likely to occur than static risks, but are also less predictable.
Static risks are more suited to management through insurance.
3) Pure Risks Vs Speculative Risks

The distinction between pure and speculative risks, rest primarily on profit loss structure of the
underlying situation in which the event occurs.
A. Pure Risk:
 Pure risk is defined as a situation in which there are only the possibilities of loss or
not loss but no chance of gain/profit.
 The only possible outcomes are adverse (loss) and neutral (no loss). For instance,
owner of automobile faces the risk of a collusion loss. If collusion occurs, he will
suffer financial loss. If there is no collusion, the owner does not gain.
 Other examples of pure risk include premature death, industrial accidents, terrible
medical expenses, and damage to property from fire, lightning, flood, or earthquake.
 Most pure risks are insurable. They are always undesirable and hence people take
steps to avoid such risks.
 Pure risks that exist for individuals and business firms can be classified under one of
the following:
1) Personal Risk
 Personal risks are risks that directly affect an individual
 This refers to the possibility of loss to a person such as: death, disability,
loss of earning power, etc.
 These consist of the possibility of the loss of income or assets as a result
of the loss of the ability to earn income. Both individual and business
face losses.
In general, earning power is subject to four perils:

 Premature death: is defined as the death of a household head with unfulfilled financial
obligations. These obligations can include dependents to support, a mortgage to be paid
off, or children to educate. If the surviving family members receive an insufficient
amount of replacement income from other sources or have insufficient financial assets to
replace the lost income, they may be financially insecure. Example: A known engineer
may die because of accident. He was important for the organization. Therefore, it is
premature death. It is peril.
 Dependent old age: Example, if a person is retired his income may decrease.
 Sickness or disability: For instance, if a person is sick, he may not generate income.
This will result in a loss in income.
 Unemployment: Example, when a person is unemployed, he will not generate the
income. Unemployment can result from business cycle downswings, technological and
structure changes in the economy, seasonal factors, and imperfections in the labor
market. Unemployment can be classified in different ways.
a) Aggregate unemployment: it affects the entire economy
b) Selective/unstructured/type of unemployment: it affects a particular
business organization. For instance, if the business organization
unable to compete the market, it will result unemployment.
c) Personal unemployment: it affects the worker/individual. Example:
if a person is unemployed because of disciplinary measures,
preferring other jobs, lack of interest
2) Property Risks
 Refers to losses associated with ownership of the property, such as destruction of property
by fire.
 the risk of having property damaged or lost from numerous causes.
 the property can be building, car, real estate and personal property can be damaged or
destroy because of fire, lightning, tornadoes, windstorms, and numerous other causes.
 Property risks embrace two distinct types of loss:
i) Direct loss and ii) Indirect loss
a. Direct loss: A direct loss is defined as financial loss that results, from the physical
damage, destruction, or theft of the property. For example, if you own a hotel that is
damaged by a fire, the physical damage to the hotel is known as a direct loss.
b. Indirect loss or Consequential loss: is a financial loss that results indirectly from
the occurrence of a direct physical damage or theft loss OR it is the losses that are
going to be incurred because of direct loss. Thus, in addition to the physical damage
loss, the hotel would lose profits for several months while the hotel is being rebuilt.
The loss of profits would be consequential loss. Other examples of a consequential
loss would be the loss of rents, the loss of the use of building, and the loss of a local
market.
3) Liability Risk:
 Refers to the intentional or unintentional injury or damage made to other persons or to their
property.
 Under our legal system, you can be held legally liable if you do something that result in
bodily injury or property damage to someone else. A court of law may order you to pay
substantial damages to the person you have injured.
 Example: A given pastry may face product liability if the cake it makes create health
problem on customer due to sanitation problem and people suffer from that act and demand
compensation by the court of law.
4) Risk Arising from the Failure Others

 When another person agrees to perform a service for you, he/she undertakes an obligation
which you hope is met. When the person failed to meet this obligation, you will incur
financial loss. Therefore, risk exists.
 Example: Failure of a contractor to complete a construction project as scheduled or failure of
debtors to make payments as expected.
B. Speculative Risk:
 Speculative risk is defined as a situation in which either profit or loss is possible.
 For example, if you purchase 100 shares of common stock, you would profit if the price of
stock increases but would loss if the price declines.
 Other examples, of speculative risk include betting on horse race, card games, investing in
real estate, and going into business for yourself, keeping dollar gambling. In these
situations, both profit and loss are possible.
Distinguish between pure and speculative risks:

 First, private insurers generally insure only pure risk. With certain exceptions, speculative
risk generally is not considered insurable, and other techniques for managing with
speculative risk must be used.
 Pure risks are distasteful (involuntarily accepted), but speculative risks posse some
attractive features (voluntarily accepted).
 Second, the law of large numbers can be applied more easily to pure risks than to
speculative risks. The law of large numbers is important because it enables insurers to
predict future loss experience.
 In contrast, it is generally more difficult to apply the law of large numbers to speculative
risks to predict future loss experience. An exception is the speculative risk of gambling
where nightclub operators can apply the law of large numbers in a most efficient manner.
 Finally, Society may benefit from a speculative risk even though a loss occurs, but it is
harmed if a pure risk is present and a loss occurs. Example, a firm may develop new
technology for producing low price computers. As a result, some competitors may be
forced to bankruptcy. Despite the bankruptcy, society benefits because the computers are
produced at a low cost. However, society normally does not benefit when as loss from a
pure risk occurs, such as flood, or earth quake.
4) Subjective Versus Objective risks

These two types of risk are also mentioned as measurable and non measurable risk
A) Subjective Risk
 is defined as uncertainty based on a person’s mental condition or state of mind. It is also
called as psychological uncertainty
 Refers to mental state of an individual as to the occurrence of certain event in a specific
period of time.
 It is the psychological uncertainty that arises from an individual’s mental attitude or state
of mind. For example, a customer who was drinking heavily in a bar may foolishly
attempt to drive home. The driver may be uncertain whether he will arrive home safely
without being arrested by the police for drunk driving. This mental uncertainty is called
subjective risk.
B) Objective Risk
 Is “the variation that exists in nature and is the same for all persons facing the same
situation.” It is the state of nature.
 It is measurable by using statistical measures like standard deviation, variation and etc.
 It differs from subjective risk primarily in the sense that is more precisely observable
and therefore measurable.
 For example, assume that a property insurer has 10,000 houses insured over a long
period and, on average, 1 %, or 100 houses, burn each year. However, it would be rare
for exactly 100 houses to burn each year. In some years, as few as 90 houses may
burn; in other years, as many as 110 houses, may burn. Thus, there is a variation of 10
houses from the expected number of 100, or a variation of 10%. This relative variation
of actual loss from expected loss is known as Objective Risk.
 Objective risk declines as the number of exposures increases. Objective risk varies
inversely with the square root of the number of cases under observation.
 As the number of exposures increases, an insurer can predict its future loss experience
more accurately because it can rely on the law of large number.
 The law of large numbers states that the number of exposure units’ increases, the more
closely the actual loss experience will approach the expected loss experience. For
example: as the number of houses under observation increases, the greater is the
degree of accuracy in predicating the proportion of houses that will burn.
5) Fundamental Risk Versus Particular Risks

The distinction between fundamental and particular risks is based on the differences in origin
and consequences of the losses.
i. Fundamental Risk:
 A fundamental risk is a risk that affects the entire economy or large numbers of
persons or groups within the economy.
 Involve losses that are impersonal in origin and consequence
 They are group risks caused for the most part by economic, social and political
phenomena.
 They affect a large number of society and they are not the fault of anyone.
 Generally speaking, fundamental risks are uninsurable
 Examples include rapid inflation, deflation, cyclical unemployment, and war because
large numbers of individuals are affected.
 The risk of a natural disaster is another important risk such as hurricanes, tornadoes,
earthquakes, floods, and forest and grass fires can result in billions of dollars of property
damage and numerous deaths. More recently, the risk of a terrorist attack is rapidly
emerging as fundamental risk.
ii. Particular Risk:

 A particular risk is a risk that affects only individuals and not the entire community.
 Involve losses that arise out of individual events and that are felt by individuals rather
than large number of society
 Particular risks are risks personal in origin and effect
 Only individuals experiencing such losses are affected, not the entire economy.
 Are more readily controlled, because they are so largely personal in origin.
 Examples include car thefts, gold thefts, bank robberies, and dwelling fires.
Note:
 Particular risks are always pure risks, where as fundamental risks include pure and
speculative risks.
 Unlike fundamental risk, particular risks are insurable.
 Fundamental risks are those that affect large populations while Particular risks affect only
specific persons. A train crash is a fundamental risk while a theft is a particular risk.
Insurance business deals with personal risks, but fundamental risks affect the life
insurance company’s experience, as many people will be affected at the same time, when
there is an earthquake, flood or riot.
------------- THE END OF CH01 ------------

HAVE A NICE STUDY!!!
CHAPTER TWO {2}

2. RISK MANAGEMENT
2.1. Definition of Risk Management

Risk management is a process that identifies loss exposures faced by an organization and
selects the most appropriate techniques for treating such exposures. In the past, risk managers
generally considered only pure loss exposures faced by the firm. However, newer forms of risk
management are emerging that consider certain speculative risks as well. This chapter discusses
only the treatment of pure risks or pure loss exposures.
2.2. Objectives of Risk Management

Risk management has important objectives. These objectives can be classified as:
1. Pre loss Objectives
2. Post loss Objectives
1. Pre loss Objectives: Important objectives before a loss occurs include economy,
reduction of anxiety, and meeting legal obligations.
Economy: The economy objective means that the firm should prepare for
potential losses in the most economical way. This preparation involves an analysis
of the cost of safety programs, insurance premiums paid, and the costs associate
with different techniques for handling losses.
Reduction of Anxiety: Certain loss exposures can cause greater worry and fear for
the risk manager and key executives. For example, the threat of a terrible court case
from a defective product can cause greater anxiety than a small loss from a minor
fire. This risk manager, however, wants minimize the anxiety and fear associated
with all loss exposures.
Meeting legal obligations: The final objective is to meet any legal obligations. For
example, government regulations may require a firm to install safety devices to
protect workers from harm, to dispose of harmful waste material properly and to
label consumer products appropriately. The risk manager must see that these legal
obligations are met.
2. Post loss Objectives: Important objectives after a loss occurs include survival,
continued operation, stability of earnings, continued growth, and social responsibility.
 Survival: The most important post loss objective is survival of the firm. Survival
means that after a loss occurs, the firm can resume at least partial operations within
some reasonable time period.
 Continued Operation: The second post loss objective is to continue operating. For
some forms, the ability to operate after a loss is extremely important. For example,
a public utility form most continues to provide service. Banks, post offices, dairies,
and other competitive forms must continue to operate after a loss. Otherwise,
business will be lost to competitors.
 Stability: The third post loss objective is stability of earnings. Earnings per share
can be maintained if the firm continues to operate. However, a firm may incur
substantial additional expenses to achieve this goal (such as operating at another
location), and perfect stability of earnings may not be attained.
 Continued Growth: The fourth post loss objective is continued growth of the firm.
A company can grow by developing new products and markets or by acquiring or
merging with other companies. The risk manager must therefore consider the effect
that a loss will have on the firm’s ability to grow.
 Social Responsibility: Finally, the objective of social responsibility is to minimize

the effects that a loss will have on other persons and on society. A sever loss can
adversely affect employees, suppliers, creditors and the community in general.
2.3. Steps in Risk Management Process

The risk management process involves four steps:
Step 1: Identifying potential losses (Risk Identification)
Step 2: Evaluate Potential losses (Risk Measurement)
Step 3: Select the appropriate techniques for treating loss exposure, and
Step 4: Implement and administer the program.
2.3.1. Risk Identification:

The first step in the risk management process is to identify all major and minor loss exposures.
This step involves a painstaking analysis of all potential losses. Unless the sources of possible
losses are recognized, it is impossible to consciously choose appropriate, efficient methods for
dealing with those losses should they occur. A loss exposure is a potential loss that may be
associated with a specific type of risk. Loss exposures typically classified as (Sources of Risks)
Loss Exposures (Sources of Risks):

A. Property Loss Exposures:
 Buildings, Plants, Other Structures
 Furniture, Equipment, Supplies
 Electronic data processing equipment; Computer Software
 Inventory
 Accounts receivables, Valuable papers and records
 Company planes, boats, mobile equipment.
B. Business Income Loss Exposures:

a. Loss of income from a covered loss
b. Continuing exposures after a loss
c. Extra expenses
d. Contingent Business income losses.
C. Human Resources Exposures:

a. Death of key employees/disability of key employees
b. Retirement or unemployment
c. Job-related injuries or disease experienced by workers
D. Crime Loss Exposures:
a. Holdups, robberies
b. Employees theft and dishonesty
c. Fraud and Embezzlement
d. Interest and computer crime exposures
E. Employee Benefit Loss Exposures:
a. Failure to comply with government regulation
b. Failure to pay promised benefits
c. Group life and health and retirement plan exposures
F. Foreign Loss Exposures:

a. Acts of terrorism
b. Plants, business property, inventory
c. Foreign currency risks
d. Kidnapping of key persons
e. Political risks
G. Liability Risks:
a. Defective Products
b. Sexual harassment of employees, discrimination against employees,
wrongful termination
c. Misuse of internet and e-mail transactions
 Techniques for Identifying Risks:

A risk manager has several techniques that he or she can use to identify the preceding loss
exposures. They include the following:
i. Loss Exposure Checklists: One risk identification tool that can be used both by business
and by individuals is a loss exposure checklist, which specifies numerous potential sources
of loss from destruction of assets and from legal liability. For each item of checklist, the
user asks the question, “is this a potential source of the loss to me or my firm?” In this
way, the systematic use of loss exposure checklists reduces the likelihood of overlooking
important sources of risks.
Some loss exposure checklists are designed for specific industries, such as manufacturers,
retail stores, educational institutions, or religious organizations. Such list tends to the quite
lengthy, as they attempt to cover all the exposures that various entities are likely to face.
A second type of checklists focuses on a specific category of exposure. The questions

included in the checklists usually address specific exposures in considerable detail. Thus,
these checklists can be helpful net only in risk identification but also in compiling
information necessary for an in depth evaluation of risks that are identified.
ii. The Financial Statement Method: The financial statement method was proposed by
A.H. Criddle (1962). Although this approach was intended for private originations, the
concepts, of this financial statements approach can be generalized in public sector
organizations as well. By analyzing the balance sheet, operating statements and
supporting documents, criddle maintains, the risk manager can identify property,
liability and human exposures (losses) of the organizations.
By coupling these statements with financial forecast and budgets, the risk manager can discover
future exposures. Financial statements reveal this information because every organizational
transaction ultimately involves either money or property.
iii. The Flow Chart Method: An organization’s exposure to risk also can be identified by
studying flow chart of organization’s activities and operations. These flow charts are
studies alongside the checklists of possible exposures to determine which items apply.
iv. Contract Analysis: Many of an organization risk arise from contractual relationships
with other persons and organizations. An examination of these contracts may reveal
are of exposures that are not evident from the organization’s operations and activities.
In some cases, contracts may shift responsibility to other parties.
v. Interactions with other Departments: Frequent interactions with other departments

provide another source of information on exposures of risk. These interactions may
include oral or written reports form other departments on their own initiative or in
response to regular reporting system that keep the risk manager informed of
developments. The importance of such a communications network should not be
underestimated. These departments are consistently creating or becoming aware of
exposures that might otherwise escape the risk manger’s attention. Indeed, the risk
manager’s success in risk identification is heavily dependent on the co-operation of
other departments.
vi. Interactions with Outside Suppliers and Professional Organizations: In addition to

communicating with other departments the risk manager normally interacts with
outsiders who provide services to the organizations. These, outsiders, for example,
accountants, lawyers, risk management consultants, actuaries, or loss control
specialists. The objective would be to determine whether the outsiders have identified
exposures that otherwise would be missed. Possibly, the outsiders themselves may
create new exposures.
vii. Statistical Records of Losses: Where available, statistical records of losses can be used
to identify sources of risk. These records may be available from risk management
information systems developed by consultants or in some cases, the risk manager.
These systems allow losses to be analyses according to cause, location amount and
other issues to interest. Statistical records allow the risk manager to asses’ trends in the
organization’s loss experience and to compare the organization’s loss experience with
the experience of others. In additions, these records enable the risk manager to analyze
issues such as the cause, time and location of the accidents, identify of the inured
individual and the supervisions, and any hazards or other special factors affecting the
nature of the accident.
2.3.2. Risk Measurement (Risk Evaluation)

The second step in the risk management process is to evaluate and measure the impact of losses
on the firm. This step involves estimation of the potential frequency and severity of loss.
Loss frequency refers to the probable number of losses that may occur during some given
period of time.
Loss severity refers to the probable size of the losses that may occur.
Once the risk manager estimates the frequency and severity of loss for each type of loss
exposure, the various loss exposures can be ranked according to their relative importance. For
example, a loss exposure with the potential for bankrupting the firm is much more important in a
risk management program than an exposure with a small loss potential.
In addition, the relative frequency and severity of each loss exposure must be estimate so that the
risk manager can select the most appropriate technique or combination of techniques for
handling each exposure. For example, if certain losses occur regularly and are fairly predictable,
they can be budgeted out of a firm income and treated as normal operating expenses. If the
certain type of exposure fluctuates widely, however, an entirely different approach is required.
Although the risk manager must consider both loss frequency and loss severity, severity is more
important, because a singly catastrophic loss could wipe out the firm. Therefore, the risk
manager must also consider all losses that can result from a singly events. Both the maximum
possible loss and maximum probable loss must be estimated. The maximum possible loss is the
worst loss that could possibly happen to the firm during its lifetime.
The maximum probable loss is the worst loss that is likely to happen to the firm during its
lifetime. The actual estimation of the frequency and severity of loses may be done in various
ways. Some risk manger considers these concepts informally in evaluation identified risks.
They may broadly classify the frequency of various losses into categories such as “Slight”,
“moderate”, and “certain” and many have similarly broad estimates for loss severity. Even this
type of informal evaluation is better than none at all. But as risk management becomes
increasingly sophisticated, most large firms, attempts to be more precise in evaluation risk. It is
now common to use probability distributions and statistical techniques in estimating both loss
frequency and severity.
2.3.3. Tools of Risk Management

After identifying and evaluating exposures to risk, systematic consideration can be given to
alternative methods for managing each exposure. The four basic methods available to handling
risks are:
1) Risk Avoidance
2) Loss Control
3) Risk Retention, and
4) Risk Transfer.
1. Risk Avoidance:
Risk Avoidance means a certain loss exposure is never acquired, or an existing loss exposure is
abandoned. It is conscious decision not to expose oneself or one’s firm to a particular risk of
loss. In this way, risk avoidance can be said to decrease one’s chance of loss to zero. Example:
A pharmaceutical firm that markets a drug with dangerous side effects can withdraw the drug
from the market.
The major advantage of risk avoidance is that the chance of loss is reduce to zero if the loss
exposure is never acquired. In addition, if an existing loss existing loss exposure is abandoned,
the chance of loss is reduced or eliminated because the activity or product that could produce a
loss has been abandoned.
Avoidance, however has two major disadvantages first, the firm may not be able to avoid all
losses. Example, a company may not be able to avoid the premature death of a key executive.
Second, it may not be feasible or practical to avoid the exposure. A paint factory can avoid
losses arising from the production of paint. Without paint production, however, the firm will not
be in business.
2. Loss Control:
When particular losses/ risks cannot be avoided, actions may be taken to reduce the losses
associated with them. This is method of dealing with risk is known as “Loss Control”. It is
different than the risk avoidance, because the firm or individual is still engaging in operations
that gives rise to particular risks.
Rather than abandoning specific activities, loss control involves making conscious decisions
regarding the manner in which those activities will be conducted. Common goals are either to
reduce the probability of losses or to decrease the cost of losses that do occur.
Types of Loss Control: Two methods of classifying loss control involve: focus and timing.
i. Focus of Loss Control: Some loss control measures are designed primarily to reduce
loss frequency. This form of loss control is referred to as “frequency reduction” (Loss
Prevention). For example, measurers that reduce truck accidents include driver
examinations, zero tolerance for alcohol or drug abuse and strict enforcement of safety
rules. Measures that reduce lawsuits from defective products include installation of
safety features on hazardous products, placement of warning labels on dangerous
products, and institution of quality control checks.
In contrast to frequency reduction, consider an auto manufacturer having airbags installed

in the company fleet off automobiles. This form is engaging in “severity reduction”
(Loss Reduction). It refers to measure that reduce the severity of a loss. The air bags
will not prevent accidents from occurring, but they will reduce the probable injuries that
employees will suffer if an accident does happen. Two special forms of loss reduction
are “Separation” and “Duplication”.
 Separation involves the reduction of maximum probable loss associated with

some kinds of risks. Example, a firm may disperse work operations in such a way
that on explosion or other terrible will not injure more than a limited number of
persons. (Through such separation, the firm is reducing the likely severity of
overall firm losses by reducing the size of the exposure in any one location.)
 Duplication is a very similar technique, in which spare parts or supplies are

maintained to replace immediately damaged equipment and or inventories. This
type of loss control also helps to reduce the severity of losses that do occur.
ii. Timing of Loss Control:

 First Timing Categories – Pre-Loss Activities
 Loss Prevention
 Loss Reduction
 Second Timing Categories – Concurrent Activities

Concurrent Activities: In second timing classification for loss control
measures is that of activities that take place concurrently with losses. The
activities of building sprinkler systems illustrate this concept of concurrent loss
control.
Post – Loss Activities.

Post – Loss Activities: The third category is that of post loss activities. As with
concurrent loss control, post-loss activities always have a severity-reduction focus.
For example, one is trying to salvage damaged property rather than discard it.
Thus, the partial restoration of an automobile and subsequent sale of the car to an
automobile wholesaler can reduce the overall severity of a loss due to an
automobile accident.
Potential Benefits of Loss Control:

Many of the benefits association with loss control are either readily quantifiable or can be
reasonably estimated. These may include the reduction or elimination of expense associated
with the following:
o Repair or replacement of damaged property
o Income losses due to destruction of property
o Extra costs to maintain operations following a loss
o Adverse liability of judgements
o Medical costs to threat injuries
o Income losses due to deaths or disabilities.
 Another quantifiable benefit of loss control is a reduction in the cost of other
risk management techniques used in conjunction with the loss control.
3. Risk Retention
Risk retention means that the firms retains part or all of the losses that can result from a given
loss. Retention can be Actives (Planned) or Passive (Unplanned). Active risk retention means
that the firm is aware of the loss exposure and plans to retain part or all of it, such as automobile
crash losses to a fleet of company cars. Passive risk retention, however, is the failure to identify
a loss exposure, failure to act or forgetting to act. For example, a risk manager may fail to
identify all company assets that could be damaged in an earthquake.
Retention can be effectively used in a risk management program under the following conditions:
 No other method of treatment is available
 The worst possible loss is not serious
 Losses are highly predictable.
 Funding Losses:
If retention is used, the risk manager must have some method for paying losses. The following
methods are typically used:
a) Current Net Income: The firm can pay losses out of its current net income and treat
losses as exposure for that year. A large number of losses could exceed current income,
however, and other assets may then have to be liquidated to pay losses.
b) Unfunded Reserve: An unfunded reserve is a bookkeeping account that is charged with
actual or expected losses form a given exposure.
c) Funded Reserve: A funded reserve is the setting aside of liquid funds to pay losses.
Funded reserves are not widely used by private employers, because the funds many yield
a much higher rate of return by being used in the business. Also, contributions to funded
reserves are net income tax deductible losses, however, are tax deductible when paid.
d) Credit Line: A credit line can be established with a bank, and borrowed funds may be
used to pay losses as they occur. Interest must be paid on the loan, however, and loan
repayments can aggregate any cash flow problems a firm may here.
 Advantages of Retention:
1. Save Money: The firm can save money in the long run if its actual loses are less then
the loss component in the insurance’s premium.
2. Lower Expenses: The services provide by the insurer may be provided by the firm at
a lower cost. Some expenses may be reduced, including loss adjustment expenses,
general administrative expenses, commissions and brokerage fees, loss control
expenses, taxes and fees and the insurer’s profit.
3. Encourage Loss Prevention: Because the exposure is retained, there may be a
greater incentive for loss prevention.
4. Increase Cash Flow: Cash flow may be increased because the firm can use the funds
that normally would be paid to the insurer at the beginning of the policy period.
 Disadvantages of Retention:
i. Possible higher losses: The losses retained by the firm may be greater than the loss
allowance in the insurance premium that is saved by net purchasing the insurance.
ii. Possible higher expenses: Expenses may actually be higher outside experts such as
safety engineers may have to be hired. Insurers may be able to provide loss control
and claim services less expensively.
iii. Possible higher taxes: Income taxes may also be higher.
4. Risk Transfer
The final risk management tool is risk transfer, which involves payments by one party (the
transferor) to another (the transferee or risk bearer). The transferee agrees to assume a risk that
the transferor desires to escape. Some times the degree of risk is reduced through the transfer
process, because the transferee may be in a better position to use the law of large numbers to
predict losses. In other cases, the degree of risk remains the same and is merely shifted from
transferor to the transferee for a price.
Four forms of risk transferor are hold-harmless agreements, incorporation, hedging and
insurance.
A. Hold-Harmless Agreements: Provisions inserted into many different kinds of contracts
can transfer responsibility for some types of losses to a party different than the one that
would otherwise bear it. Such provisions are called hold-harmless agreements or
sometimes indemnity agreements. The following are three different forms of hold-
harmless agreements.
a. Limited Form: The limited form merely clarifies that all parties are responsibilities
for liabilities arising from their own activities / actions. For example, A
contractors company is building an office complex for Orion Inc., A engages E
contractors to do the electrical wiring in the buildings. The limited form hold-
harmless agreement between A and E applies is responsible for any liabilities
losses arising from faulty wiring.
b. Intermediate Form: A second type of hold-harmless agreement is the intermediate

form, in which the transferee agrees to pay for any losses in which both the
transferee and transferor are jointly liable.
c. Broad Form: The broad form is the third type of hold-harmless agreements. It
requires the transferee to be responsible for all losses arising out of particular
situations regardless of fault.
B. Incorporation: Another way for a business to transfer risk is to incorporate. In this way,
the most that an incorporated firm can ever lose is the total amount of its assets. Personal
assets of the owners cannot be attached to help pay for business losses, as can be the case
with sole proprietorships and partnerships. Through this act of incorporation, a firm
transfer to its creditors the risk that it might net has sufficient assets to pay for losses and
other debts.
C. Insurance: The most widely used form of risk transfer is insurance.
D. Hedging: involves the transfer of speculative risk. It is a business transaction in which

the risk of price fluctuations is transferred to a third party known as a speculator.
2.3.4. Risk Management or Risk Administration Matrix

Type of Loss Loss Loss Appropriate Risk

Frequency Severity Management Technique
1 Low Low Retention
2 High Low Loss Prevention
3 Low High Insurance
4 High High Avoidance
------------- THE END OF CH02 ------------

HAVE A NICE STUDY!!!
CHAPTER THREE {3}

3. INSURANCE
3.1. Definition of Insurance
There is no single definition of insurance. Insurance can be defined from the viewpoint of
several disciplines, including law, economics, history, actuarial science, risk theory, and
sociology. The commission of Insurance Terminology of the American Risk and Insurance
Association has defined insurance as follows.
“Insurance is the pooling of accidental losses by transfer of such risks to
insurers, who agree to indemnify insureds for such losses, to provide other
financial benefits on their occurrence, or to render services connected with the
risk”.
3.2. Basic Characteristics of Insurance

Based on the preceding definition, an insurance plan or arrangement typically includes the
following characteristics.
 Pooling of Losses
 Payment of Accidental Losses
 Risk Transfer
 Indemnification
a) Pooling of Losses
Pooling or the sharing of losses is the heart of insurance. Pooling is the spreading of losses
incurred by the few over the entire group, so that in the process, average loss is
substituted for actuarial. In addition, pooling involves the grouping of a large number of
exposure units so that the law of large numbers can operate to prove a substantially accurate
prediction of future losses. Ideally, there should be large exposure units that are subject to
the same perils. Thus, pooling implies:
(1) the sharing of losses by the entire group, and
(2) prediction of future losses with some accuracy based on the law of large
numbers.
With respect to the first concept – loss sharing – consider this simple example. Assume that
1000 farmer in southeastern Kanas agree that if any farmer’s home is damaged or destroyed
by a fire, the other members of the group will indemnify, or cover, the actual costs of the
unlucky farmer who has a loss. Assume also that each home is worth $100,000 and one
average, one home burns each year. In the absence of insurance, the maximum loss to each
farmer is $100,000 if the home should burn. However, by pooling the loss, it can be spread
over the entire group, and if one farmer has a total loss, the maximum amount that each
farmer must pay is only $100 ($100,000/1000). In effect, the pooling technique results in the
substitution of an average loss of $100 for the actual loss of $100,000.
In addition, by pooling or combining the loss experience of a large number of exposure

units, an insurer may be able to predict future losses with greater accuracy. From the
viewpoint of the insurer, if future losses can be predicted, objective risk is reduced. Thus,
another characteristic often found in many lines of insurance is risk reduction based on the
law of large numbers.
b) Payment of Accidental Losses
A second characteristic of private insurance is the payment of accidental losses. An
accidental loss is one that the unforeseen and unexpected and occurs as a result of
chance. In other words, the loss must be accidental. The law of large numbers is based on
the assumption that losses are accidental and occur randomly. For example, a person may
slip on an icy sidewalk and bread a leg. The loss would be accidental insurance policies
do not cover intentional losses.
c) Risk Transfer
Risk transfer is another essential element of insurance. With the exception of self-insurance,
a true insurance plan always involves risk transfer. Risk transfer means that a pure risk is
transferred from the insured to the insurer, who typically is in a stronger financial
position to pay the loss than the insured. From the viewpoint of the individual, pure risks
that are typically transferred to insurers include the risk of premature death, poor health,
disability, destruction and theft of property, and liability lawsuits.
d) Indemnification
A final characteristic of insurance is indemnification for losses. Indemnification means
that the insured is restored to his or her approximate financial position prior to the
occurrence of the loss. Thus, if your home burns in a fire, a homeowner’s policy will
indemnify you or restore you to your previous position. If you are sued because of the
negligent operation of an automobile, your auto liability insurance policy will pay those sums
that you are legally obligated to pay. Similarly, if you become seriously disabled, a disability
income insurance policy will restore at least part of the lost wages.
3.3. Fundamentals of Insurable Risk

Insurers normally insure only pure risks. However, not all pure risks are insurable. Certain
requirements usually must be fulfilled before a pure risk can be privately insured. From the
viewpoint of the insurer, there are ideally six requirements or fundamentals of an insurable risk.
1) Large Number of Exposure Units
2) Accidental and Unintentional Loss
3) Determinable and Measurable Loss
4) No Catastrophic Loss
5) Calculable Chance of Loss
6) Economically Feasible Premium
I. Large Number of Exposure Units

The first requirement of an insurable risk is a large number of exposure units. Ideally, there
should be a large group of roughly similar, but not necessarily identical, exposure units that are
subject to the same peril or group of perils. For example, a large number of frame dwellings in a
city can be grouped together for purposes of providing property insurance on the dwellings. The
purpose of this first requirement is to enable the insurer to predict loss based on the law of large
numbers. Loss data can be compiled over time, and losses for the group as a whole can be
predicted with some accuracy. The loss costs can then the spread over all insureds in the
underwriting class.
II. Accidental and Unintentional Loss

A second requirement is that the loss should be accidental and unintentional; ideally, the loss
should be accidental and outside the insured’s control. Thus, if an individual deliberately causes
a loss, he or she should not be indemnified for the loss.
III. Determinable and Measurable Loss

A third requirement is that the loss should be both determinable and measurable. This means the
loss should be definite as to cause, time, place and amount. Life insurance in most cases meets
this requirement easily. The cause and time of death can be readily determined in most cases,
and if the person is insured, the face amount of the life insurance policy is the amount paid.
Some losses, however, are difficult to determine and measure. For example, under a disability-
income policy, the insurer promises to pay monthly benefit to the disable person if the definition
of disability stated in the policy is satisfied. Some dishonest claimants may deliberately fake
sickness or injury to collect from the insurer. Even if the claim is legitimate, the insurer must
still determine whether the insured satisfies the definition of disability stated in the policy.
The basic purpose of this requirement is to enable an insurer to determine if the loss is covered
under the policy, and if it is covered, how much should be paid.
IV. No Catastrophic Loss

The fourth requirement is that ideally the loss should not be catastrophic. This means that large
proportion of exposure units should not incur losses at the same time. As we stated earlier,
pooling is the essence of insurance. If most or all of the exposure units in a certain class
simultaneously incur a loss, then the pooling technique breaks down and becomes unworkable.
Premiums must be increased to prohibitive levels, and the insurance technique is no longer a
viable arrangement by which loses of the few are spread over the entire group.
Insurers ideally which to avoid all catastrophic loses. In reality, however, this is impossible,
because catastrophic losses periodically result from the floods, hurricanes, tornadoes,
earthquakes, forest fires, and other natural disasters. Catastrophic losses can also result from acts
of terrorism.
Several approaches are available for meeting the problems of catastrophic loss. First,
reinsurance can be used by which insurance companies are indemnified by reinsures for
catastrophic losses. Reinsurance is the shifting of part or all of the insurance originally written
by one insurer to another. Second, insurers can avoid the concentration of risk by dispersing
their coverage over a large geographical area. The concentration of loss exposures in a
geographic area exposed to frequent floods, earthquakes, hurricanes, or the natural disasters can
result in periodic catastrophic losses. If the loss exposures are geographically dispersing, the
possibility of a catastrophic loss is reduced.
Finally, new financial instruments are now available for dealing with catastrophic losses. These
instruments include catastrophe bonds, which are designed to pay for a catastrophic loss.
V. Calculable Chance of Loss:

A fifth requirement is that the chance of loss should be calculable. The insurer must be able to
calculate both the average frequency and the average severity of future losses with some
accuracy. This requirement is necessary so that a proper premium can be charged that is
sufficient to pay all claims and expenses and yield a profit during the policy period. Certain
losses, however, are difficult to insure because the chance of loss cannot be accurately estimated,
and the potential for a catastrophic loss is present. For example, floods, wars and cyclical
Unemployment occur on an irregular basis, and prediction of the average frequency and the
severity of losses are difficult. Thus, without government assistance, these losses are difficult for
private carriers to insure.
VI. Economically Feasible Premium:

A final requirement is that the premium should be economically feasible. The insured must be
able to pay the premium. In addition, for the insurance to be an attractive purchase, the
premiums paid must be substantially less than the face value, or amount, of the policy. To have
an economically feasible premium, the chance of loss must be relatively low. One view is that if
the chance of loss exceeds 40%, the cost of the policy will exceed the amount that the insurer
must pay under the contract. For example, an insurer could issue a $1,000 life insurance policy
on a man aged 99, but the pure premium would be about $980, and an additional amount for
expenses would have to be added. The total premium would exceed the face amount of the
insurance.
Based on these requirements, personal risks, property risks and liability risks can be privately
insured, because the requirements of an insurable risk generally can be met. By contrast, most
market risks, financial risks, production risks and political risks are usually uninsurable by
private insurers. These risks are uninsurable for several reasons.
3.4. Insurance and Gambling Compared

Insurance is often erroneously confused with gambling. There are two important differences
between them. First, gambling creates a new speculative risk, while insurance is a
technique for handling an already existing pure risk. If you bet $300 on a horse race, a new
speculative risk is created, but if you pay $300 to an insurer for fire insurance, the risk of fire is
already present and is transferred to the insurer by a contract. No new risk is created by the
transaction.
The second difference between insurance and gambling is that gambling is socially
unproductive, because the winner’s gain comes at the expense of the loser. In contrast,
insurance is always socially productive, because neither the insurer nor the insured is
placed in a position where the gain of the winner comes at the expense of the loser. The
insurer and the insured both have a common interest in the prevention of a loss. Both parties win
if the loss does not incur. Moreover, consistent gambling transactions generally never restore the
loser to the former financial position. In contrast, insurable contract restores the insured
financially in whole or in part if a loss occurs.
3.5. Insurance and Speculation compared

o Speculation is the business transaction in which the risk of price fluctuation is transferred to
a third party known as a speculator.
Similarities between speculation and insurance:
i. Risk is transferred by a contract
ii. No new risk is created
Differences between speculation and insurance:

1) An insurance transaction involves the transfer of insurable risks. However,
speculation is a technique for handling risks that are typically uninsurable, such
as protection against a decline in the price of agricultural products and raw
materials.
2) Insurance can reduce the objective risk of an insurer by application of the law of
large numbers. However, speculation involves only risk transfer, not risk
reduction.
3.6. Benefits & Costs of Insurance to The Society

3.6.1. Benefits of insurance to the society
The major social and economic benefits of insurance include the following:
a) Indemnification
Indemnification permits individuals, and families to be restores to their former financial position
after a loss occurs. As a result, they can maintain their financial security. Because insureds are
restored either in part or in whole after a loss occurs, they are less likely to apply for public
assistance or welfare benefits, or to seek financial assistance from relative and friends.
b) Less Worry and Fear

A second benefit of insurance is that worry and fear are reduced. This is true both before and
after a loss. For example, if family heads have adequate amounts of life insurance, they are less
likely to worry about the financial security of their dependents in the event of premature death;
persons insured for long-term disability to not have to worry about the loss of earnings if a
serious illness or accident occurs; and property owners who are insured enjoy greater peace of
mind because they know they are covered if a loss occurs.
c) Source of Investment Funds

The insurance industry is an important source of funds for capital investment and accumulation.
Premiums are collected in advance of the loss, and funds not needed to pay immediate losses and
expenses can be loaned to business firms. These funds typically are invested in shopping
centers, hospitals, factories, housing developments, and new machinery and equipment. The
investments increase society’s stock of capital goods, and promote economic growth and full
employment. Insurers also invest in social investments, such as housing, nursing homes and
economic development projects. In addition, because the total supply of loanable funds is
increased by the advance payment of insurance premiums, the cost of capital to business firms
that borrow is lower than it would be in the absence of insurance.
d) Loss Prevention
Insurance companies are actively involved in numerous loss prevention programs and also
employ a wide variety of loss prevention personnel, including safety engineers and specialists in
fire prevention, occupational safety and health, and products liability. For example, Highway
safety and reduction of automobile deaths, Fire prevention, Reduction of work related
disabilities, Prevention of auto thefts, Prevention and detection of arson losses and etc.,
e) Enhancement of Credit
A final benefit is that insurance enhances a person’s credit. Insurance makes a borrower a better
credit risk because it guarantees the value of the borrower’s collateral or give greater assurance
that the loan will be repaid. For example, when a house is purchased, the lending institution
normally requires property insurance on the house before the mortgage loan is granted.
3.6.2. Costs of Insurance to the Society

Although the insurance industry provides enormous social and economic benefits to society, the
social costs of insurance must also be recognized. The major social costs of insurance include
the following:
1) Cost of Doing Business

One important cost is the cost of doing business. Insurers consume scarce economic resources –
land, labor, capital and business enterprise - in providing insurance to society. In financial terms,
an expense loading must be added to the pure premium to cover the expense incurred by
insurance companies in their daily operations. An expense loading is the amount needed to pay
all expense, including commissions, general administrative expenses, state premium taxes,
acquisition expense, and an allowance for contingencies and profit.
2) Fraudulent Claims
A second cost of insurance comes from the submission of fraudulent claims. Examples of
fraudulent claims include the following: Auto accidents, are faked or staged to collect benefits,
Dishonest claimants fake slip and fall accidents, Phony burglaries, thefts, or acts of vandalism
are reported to insurers, False health insurance claims are submitted to collect benefits,
Dishonest policy owners take tout life insurance policies on insured who are later reported as
having dies. The payments of such fraudulent claims results in higher premiums to all insureds.
The existence of insurance also prompts some insureds to deliberately cause a loss so as to profit
from insurance. These social costs fall directly on society.
3) Inflated Claims
Another cost of insurance relates to the submission of inflated or “padded” claims. Although the
loss is not intentionally caused by the insured, the dollar amount of the claim may exceed the
actual financial loss. Examples of inflated claims include the following – Attorneys for plaintiffs
sue for high-liability judgments that exceed the true economic loss of the victim, insured inflated
the amount of damage in auto mobile collision claims so that the insurance payments will cover
the collision deductible, Disabled persons often maligner to collect disability income benefits for
a longer duration and etc. Inflated claims must be recognized as an important social cost of
insurance. Premiums must be increased to pay the additional losses. As a result, disposable
income and the consumption of other goods and services are reduced.
The End of Chapter Three (3)

Wish U a Nice Study!!!
CHAPTER FOUR:
LEGAL PRINCIPLES OF INSURANCE CONTRACT
4.1. INSURANCE PRINCIPLES
1) THE PRINCIPLE OF INDEMNITY
Indemnity states that the insurer agrees to pay no mare than the actual amount of the loss, which
means the insured should not profit from the loss or placing the insured in the same position
financially as he or she or it was in before the loss or damage took place. The two fundamental
purposes of this legal principle are: (a) to prevent the insured from profiting from loss, & (b) to
reduce moral hazard
Indemnity is different for different types of insurance:
In property insurance indemnifying the insured is based on the actual cash value of the damaged
property at time of loss. In liability insurance the insurer pays up to policy limit. In business
income insurance, the amount paid is the loss of profits and continuing expenses when the
business is shut down because of loss from a covered peril.
Exceptions to the principle of indemnity:
A policy that Pays the face amount or payment for the antiques
For example, suppose Ethiopian Airlines has 10-year-old office furniture that is destroyed by
fire. How do you think should the loss be valued? Should it be valued at what it would cost to
replace the furniture with new furniture or with comparable 10-year-old furniture (if such could
be found)?
Although replacement with new furniture would technically violate the principle of indemnity,
such is done in many property policies. You may know someone in your surrounding who might
have suffered losses due to a car accident. The car that has been destroyed could be old but when
the insurer pays compensation to the insured, a new car might be bought; hence violation of the
principle of indemnity.
Life insurance
When the insured dies, no attempt is made to measure the amount of the loss. Instead, the full
amount of life insurance policy is made upon the death of the insured.
2) PRINCIPLE OF INSURABLE INTEREST
A fundamental legal principle that strongly supports the principle of indemnity is that of
insurable interest, which states that the insured must be in a position to lose financially if a los
occurs, or to incur some other kind of harm if the loss takes place
Purposes of principle of insurable interest:

i. To prevent gambling
ii. To reduce moral hazard
iii. To measure the amount of the insured loss ( in property insurance)
Insurance contracts must be supported by an insurable interest.
There is difference between an insurable interest in property and liability and life insurance.
Insurable interest in property and liability insurance:
a. Ownership of property can support an insurable interest because he /she losses

financially if his /her property is damaged.
b. Potential legal liability also can support an insurable interest in the property of
customer because these firms are legally liable for damage to the customer goods
caused by their negligence.
E.g. Garage operators have an insurable interest in the stored automobiles for which they have
assumed liability.
c. Secured creditors also have an insurable interest in the property pledged to them.
E.g. Mortgagees, have an insurable interest in the property on which they have worked because
they have a mechanic’s lien.
d. A contractual right also can support an insurable interest
e.g. The holder of a contract to receive oil royalties has an insurable interest in the oil property so
that in the event of an insured loss, indemnity can be collected, the amount of the indemnity
being measured by the reduction in royalty resulting from the insured loss.
e. The legal ownership of the property can support an insurable interest.
E.g. St. Mary’s College might have leased a building under a long-term lease whereby the lease
may be cancelled if a fire destroys a certain percentage of the value of the building. In this case
the College has insurable interest though it does not own the building.
Insurable interest in life insurance:
There is no question of insurable interest if the life insurance is purchased on their own life and
any one the beneficiary regardless of whether the beneficiary has an insurable interest. If the life
insurance policy is purchased on the life of another person this person should have an insurable
interest on that person’s life. Close ties of blood or marriage or a pecuniary interest will satisfy
the insurable interest requirement in life insurance. a business firm may insure the life of a key
employee because that person’s death would cause financial loss to the firm. A wife may insure
the life of her husband because his continued existence is valuable to her and she would suffer a
financial loss upon his death. Likewise, a husband may insure the life of his wife because her
continued existence is valuable to him and he could suffer a financial loss upon her death. The
same statement may apply to almost anyone who is dependent on an individual. A father may
insure the life of a minor child, but a brother may not ordinarily insure the life of his sister. In the
latter case there would not usually be a financial loss to the brother upon the death of his sister,
but in the former case the father would suffer financial loss upon the death of his child. A
creditor has an insurable interest in the life of a debtor because the death of the debtor would
subject the creditor to possible loss.
When the insurable interest must exist?

In property insurance, the insurable interest must exist at the time of the loss not at the inception
of policy. If at the time of the loss the insured no longer has an interest in the property, there is
liability under the policy. E.g. suppose X Company owns and insures an automobile. Later X
sells the car to Y Company, and shortly thereafter the auto is destroyed. X Company, which has
no further financial interest in the car, cannot collect under the policy. Further, Y has no
protection under the policy because insurance is said to follow the person and not the property.
In other words, the policy purchased by X company is not transferred to Y when the car is sold.
Y would have to obtain its own coverage to be able to collect when the loss occurs.
In life insurance, the insurable interest must exist at the inception of the policy, not at the time of
the loss. The courts view life insurance as an investment contract. Assume that a wife who owns
a life insurance policy on her husband later obtains a divorce. If she continues to maintain the
insurance by paying the premiums, she may collect on the subsequent death of her former
husband even though she is remarried and suffers no particular financial loss upon his death. It is
sufficient that she had an insurable interest when the policy was first issued.
3) PRINCIPLE OF SUBROGATION
The principle of subrogation strongly supports the principle of indemnity. Subrogation means
substitution of the insurance in place of the insured for the purpose of claiming indemnity from a
third person for a loss covered by insurance. In other word one who has indemnified another’s
loss is entitled to recovery from any liable third parties that are responsible. Suppose somebody
by the name Daniel negligently causes damage to some other person’s property, say, Hanna’s. If
Hanna has already insured her property against accidental losses, her insurance company will
indemnify her to the extent of the loss. And now the insurer would have the right to proceed
against Daniel for any amounts it has paid out under Hanna’s policy. In other words the insurer,
after compensating the insured, would have every right to claim payment from the party that is
responsible for the loss.
Purposes of the principle of subrogation:
-To prevent the insured from collecting twice for the same loss.
In the example we have mentioned above, if Hanna’s insurer did not have the right of
subrogation, it would be possible for her to recover from the policy and then recover again in a
legal action against Daniel. In this way Hanna might collect twice. It would also be possible for
Hanna to arrange an accident with Daniel, Collect twice, and then split the profit with him. This
obviously would result in a moral hazard; that is making insurance contract an instrument of
fraud rather than what it has been intended for.
- To hold the negligent person responsible for the loss.
In other words, negligent parties should not escape penalty because of the insurance mechanism.
But had it not been for this principle of subrogation, the loss caused by some one will be paid for
by the insurer and the party causing the loss might not be made to pay for the pain he/ she has
caused.
- To hold down insurance rates.
In some lines of insurance, particularly liability insurance, recoveries from negligent parties
through subrogation are substantial. Although no specific provision for subrogation recoveries is
made in the rate structure other than through those provisions relating to salvage, the rates would
tend to be higher if such recoveries were not permitted. But due to this principle, insurance
companies know that they are going to get part of what they have paid out as compensation and
hence tend to charge lower premiums.
Exception to the principle of subrogation:
The principle of subrogation does not normally exist in such lines as life insurance and most
types of health insurance. Also, subrogation does not give the insurer the right to collect against
the insured, even if the insured is negligent. Thus, a homeowner who negligently, but
accidentally, burns down the house while thawing a frozen water pipe with a blowtorch can
collect under a fire policy, but the insurer cannot proceed against the owner of the policy for
compensation. Otherwise, there would be little value in having insurance. Sometimes, an insurer
might agree to waive his right of subrogation. Another interesting point we may raise her in
connection with this principle is about the interesting ethical issues for the insurer and the
insured that the interaction between the subrogation clause and the need to waive subrogation
rights can raise. For illustrative purposes, consider the case of an insured who owned property, of
which a portion was leased to another individual, named Mohammed. Say, as part of the lease
agreement, there was a waiver excusing Mohammed from liability for destruction of the property
by fire.
On the date within the insured’s policy period, a fire destroyed the property. The insured made a
claim for recovery of the damages from the insurer. After an investigation of the blaze, the
insurer determined that the damages were caused as a direct result of Mohammed’s negligence.
Thus, the insurer paid the amount of the damages to the insured and then started proceedings
against Mohammed defended on the grounds that the contract between him and the insurer
constituted a waiver-of –subrogation clause.
Say the court decided in favor of Mohamed. The court held that the owner’s fire insurer was not
entitled to subrogation against Mohammed for the fire loss paid to the owner. The insurer’s right
to subrogation could not extend beyond the insured’s own rights, and the lease agreement limited
the ability to subrogate for fire losses. Thus, because the owner had no rights to collect from
Mohammed, the insurer had no subrogation rights against him either.
Finally, note that the insurer is entitled to subrogation only after the insured has been fully
indemnified. If the insured has borne part of the loss (perhaps due to inadequate coverage), the
insurer may claim recovery only after these costs have been repaid. The only exception to this
rule is that the insurer is entitled to legal expenses incurred in pursuing the subrogation process
against a negligent third party. For example, assume that X Company’s building, valued at
600,000 Birr and insured for 500,000 Birr, is totally destroyed through the negligence of
contractor Y. X Company’s insurer subrogates against Y and collects 500,000 Birr and has legal
expenses of 500,000 Birr. The insurer receives 500,000 Birr for legal expenses, Company X
receives the 100,000 by which he was underinsured, and the insurer receives the remaining
500,000 Birr.
4) Principle of utmost good faith
The principle of utmost good faith states that both parties to an insurance contract must exercise
“utmost good faith” which means that the insured must disclose all material facts about the item
or risk to be insured to the insurers, whilst the insurers must disclose to the insured the full
details and terms of the insurance to be provided. Both parties should not engage in intentional
concealment, misrepresentation and fraud. This principle of utmost good faith is supported by
four important legal doctrines: representation, concealment, breach of warranties and
mistakes.
1. Representation:
It is a statement made by an applicant for insurance before the policy is issued or it is a statement
of his/her age, weight, occupation, state of health, family and personal history. An example of a
representation in life insurance would be answering yes or no to a question as to whether or not
the applicant had been treated for any physical condition or illness by a doctor within the
previous five years. If a representation is relied on by the insurer in entering into the contract and
if it proves to have been false at the time it was made or becomes false before the contract is
signed there exists a legal ground for the insurer to avoid the contract as the insured has violated
the principle of utmost good faith.
But every misrepresentation does not lead to avoidance of the contract. The misrepresentation
must be material enough for the insurer to cancel the contract.
Misrepresentation is said to be material if the information concealed or misrepresented

significant that, if the truth had been known, the contract either would not have been issued
would have been issued on different terms. Therefore, the insurer will waive the subrogation
clause in the manufacturer’s insurance policy because to enforce it would mean that the insured
would not be compensated at all. Inserting a waiver of subrogation clause in the manufacturer’s
insurance policy can perform this waiver. It is a common practice in insurance contracts includes
such clauses.
An insured who acts in such a way as to destroy or reduce the value of the insurer’s right of
subrogation violates the provisions of most subrogation clauses and forfeits all rights under the
policy. For instance, suppose Abebe collides with Eyob in an automobile accident. Abebe writes
Eyob term. If the misrepresentation is inconsequential, its falsity will not affect the contract.
However, a misrepresentation of a material fact may make the contract voidable at the option of
the insurer. The insurer may decide to affirm the contract or to avid it. Failure to cancel contract
after first learning about the falsity or a material misrepresentation may operate to defeat the
insurer’s rights to cancel at a later time.
What if the misrepresentation is unintentional?
Sometimes an insured might give wrong information unintentionally and this information might
be material enough to affect the contract. Thus if they make an innocent mistake about a fact
they believe to be true, They are held accountable for their carelessness. Thus, suppose W/o
Tsehay applies for insurance on her automobile and states that there is no driver under age 25 in
her family. However, it turns out that her 16-year-old son has been driving the family car without
his mother’s knowledge. Lack of this knowledge is no defense when the insurance company
refuses to pay a subsequent claim on the grounds of material misrepresentation. It is not
necessary for the insurer to demonstrate that a loss occurred arising out of the misrepresentation
in order to exert its right to avoid the contract. Thus, in the preceding case, assume Tsehay has an
accident and it is then learned for the first time that she has a 16-year-old son driving. Since this
situation is contrary to the information Tsehay had previously stated, the insurer might legally
refuse payment in most of the cases.
If the court holds that a statement given in the application was one of opinion, rather than fact,
and it turns out that the opinion was wrong, it is necessary for the insurer to demonstrate bad
faith or fraudulent intent on the part of the insured in order to avoid the contract. For example,
say one of your friends goes to Africa Insurance Company to purchase health insurance policy.
And on the application form he was asked whether he ever had cancer or not and he answers no.
Later he discovers that he actually had cancer. The court might well find that your friend has not
told the exact state of his health and thought that he had some other ailment. If the question had
been phrased, “Have you ever been told you had cancer?” a yes or no answer would clearly be a
fact, not an opinion. An honest opinion should not be a ground for rescinding an insurance
policy.
 Whether intentional or unintentional, a material misrepresentation of information by the

insured might give the insurer legitimate ground for cancellation of contracts.
2. Warranties:
A warranty is a clause in an insurance contract holding that before the insurer is liable, a certain
fact, condition, or circumstance affecting the risk must exist. For example, an insurance policy
covering a ship may state “warranted free of capture or seizure.” This statement means that if the
ship is involved in a war skirmish, the insurance is void. Or a bank may be insured on condition
that a certain burglar alarm system be installed and maintained. Such a clause is a condition of
coverage and acts as a warranty. A warranty creates a condition of the contract, and any breach
of warranty, even if immaterial, will void the contract. This is the central distinction between a
warranty and a representation. A misrepresentation does not void the insurance unless it is
material to the risk, whereas under common law any breach of warranty, whether it is material or
not, voids the contract.
 Unlike representations which need to be material enough to lead to cancellation of insurance

policies, any breach or warranty gives sufficient ground to the insurer to void insurance
contracts.
3. Concealments:
Concealment is defined as silence when obligated to speak. Concealment has approximately the
same legal effect as a misrepresentation of a material fact.
What difference do concealment and representation have?
Concealment is the failure of an applicant to reveal a fact that is material to the risk, while
misrepresentation refers to deliberate action of giving wrong information about the risk being
insured. As insurance is a contract of utmost good faith, it is not enough that the applicant
answers truthfully all questions asked by the insurer before the contract is effected. The applicant
must also volunteer material facts, even if the disclosure of such facts might result in rejection of
the application or the payment of a higher premium. The applicant is often in a position to know
material facts about the risk that the insurer does not. To allow these facts to be concealed would
be unfair to the insurer. After all, the insurer does not ask questions such as “ Is your building no
on fire?” or “Is your car now wrecked?” The most relentless opponent of an insurer’s defense
suit would not argue that an insured who obtained coverage under such circumstances would be
exercising even elementary fairness. The important, often crucial, question about concealment
lies in whether or not the applicant knew the fact withheld to be material.
What sort of questions would you use to test whether or not the insured is
concealing?
The following questions might be useful in testing concealment:
 Did the insured know of a certain fact?
 Was this fact material?
 Was the insurer ignorant of the fact?
 Did the insured know the insurer was ignorant of the fact?
The test of materiality is especially difficult because often the applicant is not an insurance
expert and is not expected to know the full significance of every fact that might be of vital
concern to the insurer. The final determination of materiality is the same as it s in the law of
representation, namely, would the contract be issued on the same terms if the concealed fact had
been known? There are two rules determining the standard of care required of the applicant. The
stricter rule, which usually applies only to ocean vessels and their cargoes, holds that
international concealment as well as innocent concealment can void the contract. In this case, the
fourth test for concealment is irrelevant. For most other risks, however, the rule is that a policy
cannot be avoided unless there is fraudulent intent to conceal material facts. Thus, the intentional
withholding of material facts with an intent to deceive constitutes fraud. In determining which
facts must be disclosed if known, it has been held that facts of general knowledge or facts known
by the insurer need not be disclosed. There is also the inference from past cases, though not a
final determination, that the insurer cannot void a contract on the grounds of concealment of
those facts that are embarrassing or self-disgracing to the applicant.
 In must cased insurance policies will be made void only incases of intentional concealments.
4. Mistakes:
When an honest mistake is made in a written contract of insurance, steps can taken to correct it
after the policy is issued. Generally, a policy can be reformed if there is proof of a mutual
mistake or a mistake on one side that is known to be a mistake by the other party, where no
mention was made of it at the time the agreement was made was not the one stated in the
contract.
As an illustration of this, consider an insurer that issued a 1,000 Birr life insurance policy and, by
an error of one of its clerks, included an option at the end of 20 years to receive income
payments of 1,051 Birr per year, rather than 10.51 Birr per year. The mistake was discovered 18
years later. When the insurer tried to correct the error, the insured refused to accept payment of
the smaller amount. In a legal decision, the court held that the mistake was a mutual one that
should be corrected. The error of the insurer was in misplacing a decimal point, whereas the error
of the insured was either in not noticing the error or, if noticed, in failing to say anything. Thus,
the correct, smaller payment was substituted for the larger, incorrect one stated in the policy.
In contrast to the previous example, suppose Adam believes himself to be the owner of certain
property and insures it. He cannot later demand the entire premium back solely because he
discovers that, in fact, he was not the owner of the property. This was a mistake in judgment or
an erroneous supposition, and the courts will not relieve that kind of mistake.
CHAPTER FIVE: LIFE AND HEALTH INSURANCE

Life Insurance
A human life has economic value to all whom depend on the earning capacity of that life,
particularly to two control economic groups- the family and the employer. To the family, the
economic value of a human life a probably most easily measured by the value of the earning
capacity of each of its members. To the employer, the economic value of human life is measured
by the contribution of an employee to the success of the business firm. If one argues that in a
free competitive society a worker is paid according to the worth and is not exploited, the
worker’s contribution again is best measure by earning capacity. It develops the earning
capacity probably the only feasible method of giving measurable economic value to human life.
There are four main perils that can destroy wholly or partially, the economic value of a human
life. These include “premature death, loss of health, old age and unemployment”.
For many people, the risk management tool that is most appropriate for dealing with the
exposure of premature death is “Life Insurance”. Every persons faces two basic contingencies
concerning life; he may die too soon, or he may live too long, to suit himself, it means that he
may outlive his financial usefulness or his ability to provide for his needs. The first category is
physical death. The second is economic death. A man, who is forced to retire at 60 from his job,
unless he has substitute income, is financially dead. Economic death may also occur at early
ages if the person becomes too disabled or ill to work. Life insurance is designed to provide
protection against these two distinct risks premature death and superannuation. Thus, life
insurance may be defined as a special and economic devise by which a group of people may
co-operate to ameliorate (make better) the loss resulting form the premature death or living
too long the members of the group.
Characteristics of Life Insurance:
A. The event insured against is an eventual certainty. No one lives forever or maintains
his economic value. Yet we do not violate the requirements of an insurable risk in the
case of life insurance for it’s is not the possibility of death itself that we insurance
against, but rather untimely death. The uncertainty surrounding the risk in life insurance
is not whether the individual is going to die, but when.
B. Life insurance is not a contract of indemnity. In most lines of insurance, an attempt is
made to put of individual back in exactly the same financial position after a loss as before
the loss. For obvious reasons, this is not possible in life insurance the simple fact of the
matter is that we cannot place exact value on a human life.
C. Insurance as a legal principle, every contract of insurance must be supported by an
insurable interest, but in life insurance the requirement of insurable interest is applied
somewhat differently than in property and liability insurance. When the individual taking
out the policy is also the insured, there is not legal problem concerning insurable interest.
The important question of insurable interest arises when the person taking out the
insurance is someone other than the person whose life is concerned. In such cases, the
law required than an insurable interest exists at the time the contract is taken out. There
are many relationships, as stated earlier, than provide the basis for an insurable interest.
D. Life contract are long-term contracts. Nearly all life policies are intended to continue
until the insured’s death or at least for several years. Other forms of insurance policies
may be renewed many times, but are usually twelve-month contracts, which may be
terminated by either party.
E. Finally, the question of over insurance is immaterial in life insurance contracts.
Types of Life Insurance Contracts
From a generic viewpoint, life insurance policies can be classified as either Term insurance or
cash-value life insurance. Term insurance provides temporary protection, while cash-value life
insurance has a savings component and builds cash values. Numerous variation and
combinations, of these two types of life insurance are available today.
TERM INSURANCE:
It provided protection only for a definite period (term) of time. A term insurance policy is
contract between the insured and the insurer where by the insurer promises to pay face
amount of the policy to a third party (the beneficiary) should the insured die within a given
period of time. If the insured does not die during the period for which the policy was taken, the
insurance company is not required to pay anything. Protection ends when the term of years
expires. In other words, term life insurance look like automobile insurance, fire insurance, and
the like, which are always term insurance. Term insurance is sometimes called temporary
insurance. Common types of term life insurance are 1 year term, 5 year term, 10 years term, 20
years term, and term to age 60 to 65.
Types of Term Insurance:
A wide variety of term insurance products are sold today. They include the following:
Yearly renewable term
5-,10-,15- or 20 year term
Term to Age 65
Decreasing term
Reentry term
Yearly renewable term: Yearly renewable term insurance is issued for a one-year period,
and the policy owner can renew for successive one year periods to some stated age without
evidence of insurability. Premiums increase with age at each renewal date. Most yearly
renewable term policies also allow the policy owner to convert to a cash-value policy.
5-, 10-, 15- or 20 year term: Term insurance can also be issued to 5, 10, 15, or 20 years, or for
longer periods. The premiums paid during the term period are level, but they increase when the
policy is renewed.
Term to Age 65: A term to age 65 policy provides protection to age 65, at which time the
policy expires. The policy can be converted to a permanent plan of insurance, but the decision to
convert must be exercised before age 65. For example, the insurer may require conversion to a
permanent policy before age 60. Because premiums are level, the policy develops a small
reserve that is used up by the end of the period.
Decreasing term insurance: Decreasing term insurance is form of term insurance where the
face amount gradually declines each year. Although the face amount declines over time, the
premium is level (same) throughout the period. In some policies, the premiums are structure so
that the policy is fully paid for a few years before the coverage expires. For example, a 20 year
decreasing term policy may require premium payments for 17 years. This method avoids paying
a relatively large premium for only a small amount of insurance near the end of the term period.
Finally, decreasing term insurance can be written as a separate policy, or it can be added as a
rider to an existing contract.
Reentry term insurance: Reentry term also called revertible term is another important term
insurance product. Under a reentry term policy, renewal premiums are based on select mortality
(death) rates if the insured can periodically demonstrate acceptable evidence of insurability.
Uses of Term Insurance:
 If the amount of income that can be spent on life insurance is limited, term insurance can
be effectively used.
 Term insurance is appropriate if the need for protection is temporary.
 Term insurance can be used to guarantee future insurability.
Limitation of Term Insurance:
 Term insurance premiums increase with age and eventually reach prohibitive levels.
 Term insurance is inappropriate if you wish to save money for a specific need.
WHOLE LIFE INSURANCE: In contrast to term insurance, which provides short term
protection, whole life insurance is a cash-value policy that provides lifetime protection.
Form a historical or traditional perspective; the following two types of whole life insurance:
 Ordinary Life Insurance
 Limited – Payment Life Insurance
Ordinary Life Insurance: Ordinary life insurance also called straight life and continuous
premium whole life provides lifetime protection to age 100, and the death claim is a certainty. If
the insured is still alive age 100, the face amount of insurance is paid to the policy owner at that
time. In addition, premiums do not increase from year to year but remain level thought the
premium paying period. Under an ordinary life policy, the policy owner is overcharged for the
insurance protection during the early years and undercharged during the later years when
premiums are inadequate to pay death claims. Ordinary life insurance also has an investment or
saving element called a cash surrender value. The cash values are due to the overpayment of
insurance premiums during the early years.
Limited Payment Life Insurance: A limited payment policy is another type of traditional whole
life insurance. The insurance is permanent, and the insured has lifetime protection. The
premiums are level, but they are paid only for a certain period. For example Girma, age 35 may
purchase a 20 year limited payment policy in the amount of 25,000 Birr. After 20 years, the
policy is completely paid, up, and no additional premiums are required even though the coverage
remains in force. A paid up policy should not be confused with one that matures. A policy
matures when the face amount is paid as a death claim or as an endowment. A policy is paid up
when no additional premium payments are required. The most common limited-payment
policies are for 10, 20, 25 or 30 years. A policy can paid up at age 65 or 70 is another form of
limited payment insurance. An extreme form of limited payment life insurance is single
premium whole life insurance, which provides lifetime protection with a single premium.
Because the premiums under a limited payment policy are higher than those paid under an
ordinary life policy, the cash values re also higher.
ENDOWMENT INSURNCE:
Endowment insurance is another traditional form of life insurance. An endowment policy pays
the face amount of insurance if the insured dies within a specified period; if the insured survives
to the end of the endowment period, the face amount is paid to the policy owner at that time. For
example, if Stephanie, age 35, purchased a 20-year endowment policy and dies any time within
the 20-year period, the face amount would be paid to her beneficiary. If she survives to the end
of the period, the face amount paid to her.
VARIATIONS OF WHOLE LIFE INSURANCE
Some important variations of whole life insurance include the following:
Variable Life Insurance: Variable life insurance is fixed premium policy in which the death
benefit and cash surrender value vary according to the investment experience of a separate
account maintained by the insurer. The entire reserve is held in a separate account and is
invested in equities or other investments. The cash surrender values are not guaranteed.
Universal Life Insurance: Universal life insurance is another variation of whole life
insurance. Theoretically, universal life can be viewed as a flexible premium policy that provides
life time protection under a contract that separates the protection and saving components.
Universal life insurance has following features:
 Unbundling of protection, savings, and expense components
 Two forms of universal life insurance
 Pays a level death benefit during the early policy years.
 Provides for an increasing death benefit.
 Considerable flexibility.
 Cash withdrawals permitted.
 Favorable income tax treatment.
Variable Universal Life Insurance: This is similar to universal life insurance with two major
exceptions. First, the cash values can be invested in a wide variety of investments. Second,
there is no minimum guaranteed interest rate, and the investment risk falls entirely on the policy
owners.
Current Assumption Whole Life Insurance: Current assumption whole life insurance is a
nonparticipating whole life policy in which the cash value is based on the insurer’s current
mortality, investment, and expense experience. An accumulation account is credited with a
current interest rate that changes over time.
An Indeterminate Premium Whole Life Policy: This is a policy that permits the insurer to
adjust premiums based on anticipated future experience. The initial premiums are guaranteed for
a certain time period and can then be increased up to some maximum limit.
Modified Life Policy: Modified life policies are whole life policy in which premiums are
lower for the first three to five years and are higher thereafter.
ANNUNITIES:
An annuity maybe defined as a periodic payment to commence at a stated data and to continue
for a fixed period or for the duration of a life. The person whose life governs the duration of
payments is called the annuitant. Annuity is insurance against living too long-against outliving
one ability to provide an income for oneself.
Annuities can be classified according to several characteristics. First, annuities can be classified
as immediate or deferred, depending upon whether the benefits are payable immediately after the
purchase of the contact. The rent of annuity can be gin as soon as the annuity is purchased, in
which case the transaction is called an immediate annuity. Alternately, the rent can be beginning
at some future time in which case the annuity is called a deferred annuity. Often the rent begins
at retirement.
Second, annuities may be paid for by a single premium or by annual premiums. An annuity ca
be wholly paid up on a lump sum payment or it can be wholly paid up in lump sum payment or it
can be purchased in installments over a period of years. If the annuity is paid up at once, it is
called a single-premium annuity. If it is paid for in installments, it is known as an annual
premium annuity.
Third, annuities may cover one life or joint lives. If two or more lives are covered, the payments
may stop at the death of the first annuitant or at the death of the last annuitant. An annuity may
be issued one more than one life. For example, the agreement might be to pay a given rent
during the lifetime individuals, as long as either shall live.
This is a very common arrangement, is known as a joint and last survivorship annuity, because
the rent is payable until the last survivor dies. The rent may be constant during the entire period
or may be arranged to be reduced by, say one third upon the death of the first annuitant. Thus, a
husband and wife both ages 65 may elect to receive the proceeds of the pension of a pension plan
on a joint and last survivor basis, with an income guaranteed as long as either shall live.
LIFE INSURANCE PREMIUMS:
There are three primary elements in life insurance rate making:
 Mortality Charge.
 Interest Charge.
 Loading Charge.
Mortality: The morality table is simply a convenient method of expressing the probabilities
of living or dying at any given age. It is a tabular expression of the chance of losing the
economic value of human life. Since the insurance company assumes the risk of the individual,
and since this risk is based on life contingencies, it is important that the company know within
reasonable limits how many people will dies at each age. One the basis of past experience
actuaries are able to predict the number of deaths among a given number of people at some given
age.
Interest: Since the insurance company collects the premium in advance and does not pay
claims until the future date, it has the use of the insured’s money for some time, and it must be
prepare to pay interest on it. The life insurance companies collect vast sums of money, and since
their obligations will not mature until some time in the future, they invest this money and earn
interest on it.
Loading Charge: When a life insurance policy is sold, the insurer incurs relatively high
first-year acquisition expenses because of commissions, sales, and administrative expenses.
Thus, the premium charges must include a loading for expenses.
Net Single Premium: The net single premium is the amount that the insurer must collect in
advance to meet all the claims arising during the policy period.
Net Level Premium: It would be impractical at attempt to collect a net single premium from each
member of an insured group. Few people would have the necessary funds for an advance
payment of all future obligations. Therefore, actuaries must calculate an annual premium.
Gross Premium: Gross premium is the pure premium plus loading for he necessary
expenses of the insurer. The net level premium for life insurance represents the pure premium
that is unadjusted for the expenses of ding business. The pure premi8m is actually the
contribution that each insured makes to the aggregate insurance fund each year for the payment
of both death and living benefits.
Health Insurance
Health insurance may be defined broadly as the type of insurance that provides indemnification
for expenditure and loss of income resulting from loss health. Health insurance is insurance
against loss by sickness or bodily injury. The loss may be the loss wages caused by sickness or
accident, or it may be expenses for doctor bills, hospital bills medicine etc.,
Types of Health Insurance:
There are two types of insurance in the generic term health insurance:
1. Disability Income Insurance and
2. Medical Expense Insurance
Disability Income Insurance:
Disability income insurance is form of health insurance that provides periodic payment when the
insured is unable to work as a result of illness or injury. It may pay benefits only in the event of
sickness or only in the event of accidental bodily injury or it may cover both contingencies in
one contract. Benefit eligibility presumes a loss of income, but in practice this is usually defined
as the inability to pursue an occupation. The fact that the insured’s employer may continue his
or her wages does not reduce the insurance benefit.
The disability must be one that prevents the insured from carrying on the usual occupation. Most
policies continue payment of the benefits for only a specified maximum number of years, but
lifetime benefits are available on some contracts. However, under all loss of income policies, the
benefits are terminated as soon as the disability ends.
Certain types of accidents are excluded, for example, losses caused by war, suicide and
intentionally inflicted injuries, and injuries while in military service during wartime.
Medical Expense Insurance:
Medical expense insurance provides for the payment of the cost of medical care that results from
sickness and injury. Its benefits help meet the expenses of physicians, hospital nursing the
related services, as well as medications and supplies. Benefits may be in the form of
reimbursement of actual expenses, up to a limit, cash payments or the direct provision of
services. The medical expense may be paid directly to the provider of the services or the
insured.
Medical expense insurance is divided into four major classes:

1) Hospitalization Expense Contract
2) Surgical Expense Contract
3) Regular medical Expense Contract
4) Major medical Expense Contract
Hospitalization Expense Contract: The hospitalization contract is intended to indemnify the
insured for necessary hospitalization expense, including room and board in the hospital,
laboratory fees, nursing care, use of operating room, and certain medicines and supplies.
Hospitalization expense is usually written for a flat daily amount for a specified number of days
such 30, 120, or 365. The contract provides that costs up to the maximum benefit per day (say
50 birr, 60 birr, 70 birr etc.,) will be paid for the number of day specified, while the insured or an
eligible dependent is in the hospital.
The agreement may set birr allowance for the different items or may be on a service basis.
Typical contracts offered by insurance companies, for example may state that he insured will be
indemnified up to X birr per day for necessary hospitalization.
Exclusions under hospitalization contracts:
Like all insurance policies, hospitalization contracts offered by insures are subject to exclusions.
The following exclusions are typical of hospitalization contracts:
 Expenses resulting from war or any act of war.
 Expenses resulting from self-inflicted injuries.
 Expenses payable under worker’s compensation or any occupational disease law.
 Expenses incurred while on active duty with the armed forces.
 Expenses incurred form purely cosmetic purposes.
 Expenses incurred by individuals on an outpatient basis.
 Services received in any government hospital not making a charge for such services.
Surgical Contracts:
The surgical contract provides allowances for different surgical procedures performed by duly
licensed physicians. In general, a schedule of operations is set forth together with the maximum
allowance for each operation. It reimburses the policyholder according to a schedule that lists
the amounts the policy will pay for a variety of operations.
Regular Medical Contract: The regular medical expense insurance pays part or all of
physicians’ ordinary bills, such as his called at the patient’s home or at a hospital or a patient’s
visit to his office. It is contract of health insurance that covers physicians’ services other than
surgical procedures. Normally, regular medical insurance is written in conjunction with other
types of health insurance and is not written as a separate contract.
Major Medical Contract: The major medical expense insurance provides protection against the
very large const of serious or long illness or injury. The major medical policy is mot appropriate
for the large medical expenses that would be financially unaffordable for the individual.
The contract is issued subject to substantial deductible of different sorts and with a high
maximum limit. Since this kind of policy is designed to cover only serious illness or accidents, a
deduction is used to eliminate small claims. A major medical policy might have 5,000 birr
maximum limit for any one accident or illness, have a 200 birr deductible for any one illness, and
contain an agreement to indemnify the insured for a specified percentage of bills, such as 80%
over and above the amount of the birr deductible. This means the insurance company pays 80%
of the loss in excess of the deductible, and the insured pays the 20%. In the absence of the
coinsurance clause, there would be no incentive for the insured or the doctor to keep expenses
within reasonable limits.
CHAPTER SIX: PROPERTY AND LIABILITY INSURANCE:
General or Non-Life Insurance
General insurance or non-life insurance policies, including automobile and homeowners’
policies, provide payments depending on the loss from a particular financial event. General
insurance typically comprises any insurance that is not determined to be life insurance.
Property Insurance
Property insurance provides protection against most risks to property, such as fire, theft and
some weather damage. This includes specialized forms of insurance such as fire insurance, flood
insurance, earthquake insurance, home insurance or boiler insurance. Property insurance covers a
business's building and its contents -- money and securities, accounts-receivable records,
inventory, furniture, machinery, supplies and even intangible assets such as trademarks -- when
damage, theft or loss occurs.
Property is insured in two main ways - open perils and named perils. Open perils cover all the
causes of loss not specifically excluded in the policy. Common exclusions on open peril policies
include damage resulting from earthquakes, floods, nuclear incidents, acts of terrorism and war.
Named perils require the actual cause of loss to be listed in the policy for insurance to be
provided. The more common named perils include such damage-causing events as fire, lightning,
explosion and theft.
Some insurance companies offer property insurance by named peril, such as fire and theft.
Others offer policies that cover multiple perils. Most basic multiple-peril policies include losses
caused by fire and theft, but business owners can purchase additional types of coverage if they
need it. For example, a business in the Midwest or on the East Coast may want to purchase
coverage for snow, ice or sleet damage, while businesses on the West Coast may consider an
earthquake-insurance policy.
Businesses with good loss-control measures and claim histories often pay lower insurance
premiums than companies with risky procedures and poor claims histories. Taking steps to
prevent loss hiring security personnel to prevent shoplifting, installing a sprinkler system to
contain fires or using an alarm system to protect against theft can help control the cost of
property insurance.
Types of Coverage (Property Insurance):
Many businesses purchase property insurance through a business-owner's policy (BOP), which
bundles property and liability insurance into one policy; however, since the amount of coverage
available in a BOP is generally lower than in a standard property-insurance policy, companies
that require a lot of coverage usually stick with a separate policy.
Some BOPs also include business-interruption insurance and extra-expense insurance -- two
types of optional coverage in a property insurance policy that protect a business after a loss
occurs.
Business-interruption insurance provides payments for expenses such as salaries, taxes and
debts, as well as any loss of profit due to the interruption of business.
Extra-expense insurance pays the costs of temporarily relocating a business when a covered peril
occurs. For example, if a fire destroys a clothing store, extra-expense insurance will pay for a
business to resume operations and cover such expenses as buying or leasing equipment, getting
new merchandise and notifying customers about changes that have occurred.
Fire Insurance
There are three types of insurance coverage. Replacement cost pays the cost of replacing your
property regardless of depreciation or appreciation. Extended replacement cost will pay over the
coverage limit if the costs for construction have increased. This generally will not exceed 20% of
the limit. Actual Cash Value provides replacement minus depreciation. When you obtain an
insurance policy, the coverage limit established is the maximum amount the insurance company
will pay out in case of loss of property. This amount will need to fluctuate if homes in your
neighborhood are rising; the amount needs to be in step with the actual value of your home. In
case of a fire, household content replacement is tabulated as a percentage of the value of the
home. In case of high value items, the insurance company may ask to specifically cover these
items separate from the other household contents. One last coverage option is to have alternative
living arrangements included in a policy. If a fire leaves your home uninhabitable, the policy can
help pay for a hotel or other living arrangements.
Auto insurance
Auto insurance protects you against financial loss if you have an accident. It is a contract
between you and the insurance company. You agree to pay the premium and the insurance
company agrees to pay your losses as defined in your policy. Auto insurance provides property,
liability and medical coverage:
1. Property coverage pays for damage to or theft of your car.
2. Liability coverage pays for your legal responsibility to others for bodily injury or
property damage.
3. Medical coverage pays for the cost of treating injuries, rehabilitation and sometimes lost
wages and funeral expenses.
An auto insurance policy comprises six kinds of coverage. Most countries require you to buy
some, but not all, of this coverage. If you're financing a car, your lender may also have
requirements. Most auto policies are for six months to a year.
In the United States, your insurance company should notify you by mail when it’s time to renew
the policy and to pay your premium.
Automobile insurance, known in the UK as motor insurance, is probably the most common form
of insurance and may cover both legal liability claims against the driver and loss of or damage to
the insured's vehicle itself. Throughout the United States an auto insurance policy is required to
legally operate a motor vehicle on public roads. In some jurisdictions, bodily injury
compensation for automobile accident victims has been changed to a no-fault system, which
reduces or eliminates the ability to sue for compensation but provides automatic eligibility for
benefits. Credit card companies insure against damage on rented cars.
Driving School Insurance provides cover for any authorized driver whilst undergoing tuition;
cover also unlike other motor policies provides cover for instructor liability where both the pupil
and driving instructor are equally liable in the event of a claim.
Homeowners’ Insurance
Home insurance, also commonly called hazard insurance or homeowners insurance (often
abbreviated in the real estate industry as HOI), is the type of property insurance that covers
private homes. It is an insurance policy that combines various personal insurance protections,
which can include losses occurring to one's home, its contents, loss of its use (additional living
expenses), or loss of other personal possessions of the homeowner, as well as liability insurance
for accidents that may happen at the home. It requires that at least one of the named insured
occupies the home. The dwelling policy (DP) is similar, but used for residences which don't
qualify for various reasons, such as vacancy/non-occupancy, seasonal/secondary residence, or
age. It is a multiple line insurance, meaning that it includes both property and liability coverage,
with an indivisible premium, meaning that a single premium is paid for all risks. The insurance
policy itself is a lengthy contract, and names what will and what will not be paid in the case of
various events. Typically, claims due to floods, or war (whose definition typically includes a
nuclear explosion from any source) are excluded. Special insurance can be purchased for these
possibilities, including flood insurance. Insurance must be updated to the present and existing
value at whatever inflation up or down, and an appraisal paid by the insurance company will be
added on to the policy premium. Fire insurance will require a special premium charge, plus the
addition of smoke detectors and on site fire suppression systems to qualify.
The home insurance policy is usually a term contract a contract that is in effect for a fixed period
of time. The payment the insured makes to the insurer is called the premium. The insured must
pay the insurer the premium each term. Most insurers charge a lower premium if it appears less
likely the home will be damaged or destroyed: for example, if the house is situated next to a fire
station, if the house is equipped with fire sprinklers and fire alarms. Perpetual insurance, which is
a type of home insurance without a fixed term, can also be obtained in certain areas.
Property Insurance Types:
Property insurance provides protection against risks to property, such as fire, theft or weather
damage. This includes specialized forms of insurance such as fire insurance, flood insurance,
earthquake insurance, home insurance, inland marine insurance or boiler insurance.
 Aviation insurance insures against hull, spares, deductibles, hull wear and liability risks.
 Boiler insurance (also known as boiler and machinery insurance or equipment
breakdown insurance) insures against accidental physical damage to equipment or
machinery.
 Builder's risk insurance: insures against the risk of physical loss or damage to property
during construction. Builder's risk insurance is typically written on an "all risk" basis
covering damage due to any cause (including the negligence of the insured) not otherwise
expressly excluded.
 Crop insurance "Farmers use crop insurance to reduce or manage various risks
associated with growing crops. Such risks include crop loss or damage caused by
weather, hail, drought, frost damage, insects, or disease, for instance."
 Earthquake insurance is a form of property insurance that pays the policyholder in the
event of an earthquake that causes damage to the property. Most ordinary home owners
insurance policies do not cover earthquake damage. Most earthquake insurance policies
feature a high deductible. Rates depend on location and the probability of an earthquake,
as well as the construction of the home.
 A fidelity bond is a form of casualty insurance that covers policyholders for losses that
they incur as a result of fraudulent acts by specified individuals. It usually insures a
business for losses caused by the dishonest acts of its employees.
 Flood insurance protects against property loss due to flooding. Many insurers in the U.S.
do not provide flood insurance in some portions of the country. In response to this, the
federal government created the National Flood Insurance Program which serves as the
insurer of last resort.
 Landlord insurance is specifically designed for people who own properties which they
rent out. Most house insurance cover in the U.K will not be valid if the property is rented
out therefore landlords must take out this specialist form of home insurance.
 Marine insurance and marine cargo insurance cover the loss or damage of ships at sea or
on inland waterways, and of the cargo that may be on them. When the owner of the cargo
and the carrier are separate corporations, marine cargo insurance typically compensates
the owner of cargo for losses sustained from fire, shipwreck, etc., but excludes losses that
can be recovered from the carrier or the carrier's insurance. Many marine insurance
underwriters will include "time element" coverage in such policies, which extends the
indemnity to cover loss of profit and other business expenses attributable to the delay
caused by a covered loss.
 Surety bond insurance is a three party insurance guaranteeing the performance of the
principal. A surety bond is a contract among at least three parties: (1) The principal - the
primary party who will be performing a contractual obligation, (2) The obligee - the party
who is the recipient of the obligation, and (3) The surety - who ensures that the principal's
obligations will be performed. Surety bonds are frequently used in the construction
industry: in order to obtain a contract to build the project, the general contractor (and
often the sub-contractors as well) must provide the owner a bond for its performance of
the terms of the contract. Conversely, owners and contractors may also provide payment
bonds to ensure that subcontractors and suppliers are paid for work done.
 Terrorism insurance provides protection against any loss or damage caused by terrorist
activities.
 Volcano insurance is an insurance that covers volcano damage in Hawaii.
 Windstorm insurance is an insurance covering the damage that can be caused by
hurricanes and tropical cyclones.
Liability Insurance
Liability insurance is a very broad superset that covers legal claims against the insured. Many
types of insurance include an aspect of liability coverage. For example, a homeowner's insurance
policy will normally include liability coverage which protects the insured in the event of a claim
brought by someone who slips and falls on the property; automobile insurance also includes an
aspect of liability insurance that indemnifies against the harm that a crashing car can cause to
others' lives, health, or property. The protection offered by a liability insurance policy is twofold:
a legal defense in the event of a lawsuit commenced against the policyholder and indemnification
(payment on behalf of the insured) with respect to a settlement or court verdict. Liability policies
typically cover only the negligence of the insured, and will not apply to results of willful or
intentional acts by the insured.
 Directors and officers liability insurance protects an organization (usually a
corporation) from costs associated with litigation resulting from mistakes made by
directors and officers for which they are liable. In the industry, it is usually called "D&O"
for short.
 Environmental liability insurance protects the insured from bodily injury, property
damage and cleanup costs as a result of the dispersal, release or escape of pollutants.
 Prize indemnity insurance protects the insured from giving away a large prize at a
specific event. Examples would include offering prizes to contestants who can make a
half-court shot at a basketball game, or a hole-in-one at a golf tournament.
 Professional liability insurance, also called Professional Indemnity Insurance, protects
professional practitioners such as architects, lawyers, physicians, and accountants against
potential negligence claims made by their patients/clients. Professional liability insurance
may take on different names depending on the profession. For example, professional
liability insurance in reference to the medical profession may be called Medical
Malpractice. Notaries public may take out errors and omissions insurance (E&O). Other
potential E&O policyholders include, for example, real estate brokers, home inspectors,
appraisers, and website developers. There are also specific E&O policies for technology
companies, such as software developers, technology consultants and other creators of
technology. This coverage focuses on the failure to perform, financial loss and error or
omission of the products or services sold. Additional coverage for breach of warranty,
intellectual property, personal injury, security and cost of contract can be added.
The primary reason for professional liability coverage is that a typical general liability insurance
policy will only respond to a bodily injury, property damage, personal injury or advertising
injury claim. The above mentioned professional services and products can cause claims without
causing a bodily injury, property damage, personal injury or advertising injury. Common reasons
alleged in making claims on these policies are negligence, misrepresentation, violation of good
faith and fair dealing, and inaccurate advice. For example, if a software product fails to perform
properly, it may not cause physical damages, personal or advertising injuries, therefore the
general liability policy would not be triggered. It may, however, directly cause financial losses
which could potentially be attributed to the software developer's misrepresentation of the product
capabilities.
Professional liability insurance policies are generally set up based on a claims-made basis,
meaning that the policy only covers incidents that occurred during the timeframe in which the
coverage was active. It is important to continue your coverage, because canceling the policy, will
in effect, make it as if you never had coverage.
Credit Insurance
Credit insurance repays some or all of a loan when certain things happen to the borrower such as
unemployment, disability, or death.
Credit insurance is a term used to describe both trade credit insurance and credit life insurance.
Credit life insurance is a consumer purchase, often sold with a big ticket purchase such as an
automobile. The insurance will pay off the loan balance in the event of the death or the disability
of the borrower. Although purchased by the consumer/borrower, the benefit payment goes to the
company financing the purchase to satisfy a debt.
Credit insurance or trade credit insurance (also known as business credit insurance) is an
insurance policy and risk management product that covers the payment risk resulting from the
delivery of goods or services. Credit insurance usually covers a portfolio of buyers and pays an
agreed percentage of an invoice or receivable that remains unpaid as a result of protracted
default, insolvency or bankruptcy. Trade credit insurance is purchased by business entities to
insure their accounts receivable from loss due to the insolvency of the debtors. This product is
not available to private individuals.
The costs (called a "premium") for this are usually charged monthly, and are calculated as a
percentage of sales of that month or as a percentage of all outstanding receivables.
Credit insurance insures the payment risk of companies, not of private individuals. Policy
holders require a credit limit on each of their buyers for the sales to that buyer to be insured. The
premium rate is usually low and reflects the average credit risk of the insured portfolio of buyers.
In addition, credit insurance can also cover single transactions or trade with only one buyer.
Mortgage insurance insures the lender against default by the borrower. Mortgage insurance is a
form of credit insurance, although the name credit insurance more often is used to refer to
policies that cover other kinds of debt.
Other Types
 Collateral protection insurance or CPI, insures property (primarily vehicles) held as
collateral for loans made by lending institutions.
 Defense Base Act Workers' compensation or DBA Insurance provides coverage for
civilian workers hired by the government to perform contracts outside the U.S. and
Canada. DBA is required for all U.S. citizens, U.S. residents, U.S. Green Card holders,
and all employees or subcontractors hired on overseas government contracts. Depending
on the country, Foreign Nationals must also be covered under DBA. This coverage
typically includes expenses related to medical treatment and loss of wages, as well as
disability and death benefits.
 Expatriate insurance provides individuals and organizations operating outside of their
home country with protection for automobiles, property, health, liability and business
pursuits.
 Financial loss insurance protects individuals and companies against various financial
risks. For example, a business might purchase coverage to protect it from loss of sales if a
fire in a factory prevented it from carrying out its business for a time. Insurance might
also cover the failure of a creditor to pay money it owes to the insured. This type of
insurance is frequently referred to as "business interruption insurance." Fidelity bonds
and surety bonds are included in this category, although these products provide a benefit
to a third party (the "obligee") in the event the insured party (usually referred to as the
"obligor") fails to perform its obligations under a contract with the obligee.
 Kidnap and ransom insurance: Kidnap and ransom insurance (K&R insurance) is
designed to protect individuals and corporations operating in high-risk areas around the
world, such as Mexico, Venezuela, Haiti, and Nigeria, certain other countries in Latin
America, as well as some parts of the Russian Federation and Eastern Europe. K&R
insurance policies typically cover the perils of kidnap, extortion, wrongful detention and
hijacking. K&R policies are indemnity policies - they reimburse a loss incurred by the
insured. The policies do not pay ransoms on the behalf of the insured. The insured must
first pay the ransom, thus incurring the loss, and then seek reimbursement under the
policy. Losses typically reimbursed by K&R polices are ransom payments, loss-of-
ransom-in-transit and additional expenses, such as medical expenses. The policies also
typically indemnify personal accident losses caused by a kidnap. These include death,
dismemberment, and permanent total disablement of a kidnapped person. They also
typically pay for the fees and expenses of crisis management consultants,. These
consultants provide advice to the insured on how to best respond to the incident
 Locked funds insurance is a little-known hybrid insurance policy jointly issued by
governments and banks. It is used to protect public funds from tamper by unauthorized
parties. In special cases, a government may authorize its use in protecting semi-private
funds which are liable to tamper. The terms of this type of insurance are usually very
strict. Therefore it is used only in extreme cases where maximum security of funds is
required.
 Nuclear incident insurance covers damages resulting from an incident involving
radioactive materials and is generally arranged at the national level. See the Nuclear
exclusion clause and for the United States the Price-Anderson Nuclear Industries
Indemnity Act)
 Pet insurance insures pets against accidents and illnesses - some companies cover
routine/wellness care and burial, as well.
 Pollution Insurance, which consists of first-party coverage for contamination of insured
property either by external or on-site sources. Coverage for liability to third parties
arising from contamination of air, water, or land due to the sudden and accidental release
of hazardous materials from the insured site. The policy usually covers the costs of
cleanup and may include coverage for releases from underground storage tanks.
Intentional acts are specifically excluded.
 Purchase insurance is aimed at providing protection on the products people purchase.
Purchase insurance can cover individual purchase protection, warranties, guarantees, care
plans and even mobile phone insurance. Such insurance is normally very limited in the
scope of problems that are covered by the policy.
 Title insurance provides a guarantee that title to real property is vested in the purchaser
and/or mortgagee, free and clear of liens or encumbrances. It is usually issued in
conjunction with a search of the public records performed at the time of a real estate
transaction.
 Travel insurance is an insurance cover taken by those who travel abroad, which covers
certain losses such as medical expenses, loss of personal belongings, travel delay,
personal liabilities, etc.
\ CHAPTER 7
7. REINSURANCE
7.1. Meaning of reinsurance
Reinsurance is another important insurance operation. This section discusses the meaning of
reinsurance, the reasons, for reinsurance, and the different types of reinsurance contracts.
There are many risks in all classes of business which are too great for one insurer to bear solely
on his won account. Reinsurance is a method created to divide the task of handling risk among
several insurers. Naturally, the insuring public wishes to effect cover with one insurer and the
insurer who in these circumstances all or part of the risk with other direct insurers or with
companies which transact reinsurance business only.
Reinsurance may be defined as the shifting by a primary insurer, called the ceding company,
of a part of the risk it assumes to another company, called the re insurer. That portion of risk
kept by the ceding company is known as the line, or retention, and varies with the financial
position of the insurer and the nature of the exposure. When a re insurer passes on risks to
another re insurer, the process is known as retrocession.
It is not good business to refuse to write insurance in excess of the retention amount. Imaging
the displeasure of the applicant, particularly of the producer when the application is rejected or
accepted in part. For theses and other reasons insurers commonly insure that portion of their
liability under their contract in excess of their retention with one or more insurers. This process
is called reinsurance, the originating insurer is the “primary insurer”, or “direct insurer”,
and the accepting insurer is the “re insurer”.
7.2. Reasons for Reinsurance

Reinsurance is used for several reasons. The most important reasons include the following:
Increase underwriting capacity.
Stabilize profits.
Reduce the unearned premium reserve.

Provide protection against a catastrophic loss.
I)Increase underwriting capacity
Reinsurance can be used to increase the insurance company’s underwriting capacity to write new
business. The company may be asked to assume liability for losses in excess of its retention
limit. Without reinsurance, the agent would have to place large amounts of insurance with
several companies or not accept the risk. This is awkward and may create ill will on behalf of
the policy owner. Reinsurance permits the primary company to issue a single policy in excess of
its retention limit for the full amount of insurance.
1) Stabilize Profits
Reinsurance can be used to stabilize profits. An insurer may wish to avoid large fluctuations in
annual financial results. Loss experience can fluctuate widely because of social and economic
conditions, natural disasters, and chance. Reinsurance can be used to level out the effects of
poor loss experience. For example, reinsurance may be used to cover a large exposure. If a
large, unexpected loss occurs, the re insurer would pay the portion of the loss in excess of some
specified limit. Another arrangement would be to have to re insurer reimburse the ceding insurer
for loses that exceed a specified loss ratio during a given year. For example, an insurer may wish
to stabilize its loss ratio 70%. The re insurer then agrees to reimburse the ceding insurer for part
or all the losses in excess of 70% up to some maximum limit.
2) Reduce the unearned premium reserve
Reinsurance can be used to reduce the unearned premium reserve. For some insurers, especially
newer and smaller ones, the ability to write large amounts of new insurance may be restricted by
the unearned premium reserve requirement. The unearned premium reserve is a liability item on
the insurer’s balance sheet that represents the unearned portion of gross premiums on all
outstanding policies at the time of valuation. If effect, the unearned premium reserve reflects the
fact that premium are paid in advance, but the period of protection has not yet expired. As time
goes on, part of the premium is considered earned, while the remainder is unearned. It is only
after the period of protection has expired that the premium is fully earned.
3) Provide Protection Against a Catastrophic Loss
Reinsurance also provides financial protection against a catastrophic loss. Insurers experience
catastrophic losses because of natural disasters, industrial explosions, commercial airline
disasters, and similar events. Reinsurance can provide considerable protection to the ceding
com-any that experiences a catastrophic loss. The reinsure pays part of loss that exceeds the
ceding company’s retention up to some specified maximum limit.
4) Other Reasons for Reinsurance
An insurer can use reinsurance to retire form the business or from a given line of insurance or
territory. Reinsurance permits the insurer’s liabilities for existing insurance to be transferred to
another carrier; thus, the policy owner’s coverage remains undisturbed.
7.3. Methods of Reinsurance:

There are two main methods in which risks can be shared:

Facultative Reinsurance
Automatic Treaty
A.Facultative Reinsurance
Facultative reinsurance is reinsurance on an optional basis. There is no advance agreement
between the ceding company and the re insurer regarding the sharing of risks and premiums.
Under this arrangement a primary insurer, in considering the acceptance of a certain risk, shops
around for reinsurance on it, attempting to negotiate coverage specifically only this particular
contract. Each risk, which it offered, is described and this is shown to the prospective re insurers
who are offered, is described and this is shown to the prospective re insurers who are free to
accept or decline as they see fit. Some life insurers, for example may receive an application for
birr 1 million of life insurance on a single life. Not whishing to reject this business, but still
unwilling to accept the entire risk, the primary insurer communicates full details on this
application to another insurer with whom it has done business in a past. The other insurer may
agree to assume 40% of any loss for a corresponding percentage of the premium. The primary
insurer then puts the contract in force.
The reinsurance agreement does not affect the insured in any way. The insured is generally not
aware of the reinsurance process and the primary insurer remains fully liable to the insured in
event of loss.
As stated earlier the insurer retains the right to decide whether and how much of his risk to
submit for reinsurance. The re insurer also retains the right to accept or reject any business
offered by the insurer.
A. Automatic Treaty
Under an automatic reinsurance treaty, the ceding insurer agrees to pass on to the re-insurer all
business included within the scope of treaty, the re insurer agrees to accept this business, and the
terms e.g., the premium rates and the method of sharing the insurance and the losses of the
agreement are set. The ceding company is required to cede some certain amounts of business,
and the re insurer is required to accept him. The ceding company known in advance that it will
be able to obtain reinsurance for all exposures that meet the conditions specified in the treaty.
The amount that the ceding company keeps for its own account is known as its retention, and the
amount ceded to other is known as cession.
Forms of Reinsurance Treaties
The most important types of reinsurance treaties include:
 Quota-share reinsurance
 Surplus-share reinsurance
 Excess of loss reinsurance
i.Quota-share reinsurance
Quota share reinsurance method the direct office arranges with reinsures to cede a fixed
proportion of all its business of a certain class and the re insurer accepts that proportion in return
for a corresponding proportion of the premiums. Under quota share split, the insurance and loss
are shares according to some pre-agreed percentage. For example, if a 100,000birr policy is
written and the agreed split is 50-50, the re insurer assumes on half of the liability; the insurer
and the re-insurer each pays one-half on any loss.
The method is not greatly favored because it means paying away proportion of the premium
income where the direct office might safely retain the whole of risk. It is, however, a useful
method for small offices or those starting up a new class of business where in the early days one
or two heavy losses could swallow up all the income. The method is sometimes also used
between parent and subsidiary companies.
i. Surplus Share Reinsurance

Under surplus share reinsurance the ceding company decides what its net retention will be for
each class of business. The direct office cedes to the re insurer only those amounts, which it
does not which to should for its own account the surplus or its retention. The re-insurer does not
participate unless the policy amount exceeds this net retention. This retention is known also as a
“line” and reinsures have a maximum capacity of so many lines, or so many times the direct
office’s retention.
For example, if the agreement calls for cession of up to “ten lines” and the direct office retains
25,000 birr, then the times this amount can be ceded to the reinsure, i.e., 250,000 birr: in this
way sums insured up to 275,000 birr can be accepted by the direct insurer knowing that he
automatically has the reinsurance he requires. It is of course not necessary (or possible) to fill
the whole capacity of the reinsurance treaty on each individual acceptance: sometimes the
acceptance will be entirely within the direct insurer’s retention and the treaty will not be
interested at all, and on other occasional the treaty underwriters will only be ceded a limited
amount which they divide equally between them.
Using the earlier example of a ten-line reinsurance treaty the position of the treaty (reinsures) in
different circumstances would be as follows:
Original Sum Direct Insurer’s ceded to Treaty Proportion to Insured
Retention Treaty (reinsurance)
25,000 25,000 NIL NIL
50,000 25,000 25,000 50%
100,000 25,000 75,000 75%
275,000 25,000 250,000 90.9%
300,000 25,000 250,000* 83.3%
* The balance of 25,000 birr would have to be reinsured facultative of under a second
reinsurance treaty.
Excess of Loss Reinsurance:
In this form of reinsurance the direct insurer decides the maximum loss arising from any event or
series of events he is prepared to bear, and then arranges with re insurers for them to pay the
excess of that amount up to an upper limit. The re insurer agrees to be liable for all loses
exceeding a certain amount on a given class of business during a specific period.
For example, the primary insurer may be prepared to pay up to 50,000 birr any one loss, and he
secures reinsurance for the excess of 50,000 birr up to a further 200,000 the way in which
various losses are divided is shown below:
Loss Direct Insurer Excess Treaty (Re-insurer)

10,000 birr 10,000 birr NIL
50,000 50,000 NIL
70,000 50,000 20,000
100,000 50,000 50,000
250,000 50,000 200,000
300,000 100,000* 200,000
* i.e., its original retention of birr 50,000 birr plus a further birr 50,000 excess of the treaty’s
(reinsures) liability.
Such a contract is simple to administer because the reinsures are liable only after the
ceding company has actually suffered the agreed amounts of loss. Since the probability of large
losses is small, premiums for this reinsurance are likewise small.
GOVERNMENT REGULATION OF INSURANCE
Government has laid down rules governing the conduct of business, and insurance is no
exception. In the case of insurance (as one component of business activities) special attention
was given by the government to restructure and organize it in a new form to satisfy social and
economic interests of the general public through the proclamation No. 68 of 1975, to provide for
the establishment of Ethiopian Insurance Corporation with an initial capital of 11 million dollars.
Thus, the insurance industry was challenged and stimulated by the government to do its best.
Reasons for Insurance Regulation:
Insurers are regulated by the states for several reasons, including the following:
Maintain insurer solvency.
Equity.
Competence.
Insurable Interest.
Provision of certain forms of insurance.
National Insurance.
Maintain Insurer Solvency: Perhaps the greatest step taken by legislation was to introduce
solvency margins that were related to premium income. In this way, a ratio was established
between the margin and the amount of business undertaken. This prevented certain people with
fraudulent aims from providing insurance, and acted as a continual monitor on those already
transacting it.
Equity: The term equity has been used, but equally suitable would have been morality, fairness
or reasonableness, because each implies the fact that an element of fairness must exist between
companies and policyholders. The insurance contract is one of considerable complexity and it is
essential that controls exist for the protection of policyholders.
Competence: The buying and selling of insurance is unlike many other forms of product
purchasing. A tangible product is not being purchased; a promise to provide indemnity, an exact
compensation, is what is being bought and sold. Those who deal in such promises must be
competent persons and able to fulfill their pledges when the need arises. Therefore, regulations
are necessary in the management of insurance and investment business.
Insurable Interest: Insurable interest is one of the basic doctrines of insurance. Governments
have found it necessary to introduce legislation in order to eradicate any element of gambling. It
was not acceptable that unscrupulous persons could benefit by effecting policies of insurance
where they had no financial interest in the potential loss, other than the profit they would make if
it occurred.
Provisions of certain forms of insurance: An element of intervention has been in evidence
where forms of cover have been make compulsory, as the case of employers’ liability and third
party motor accident injuries. The intervention is not in the provision of cover by government,
but in establishing the nature of the cover to be granted.
National Insurance: For some areas of social risk, the Governments’ intervention has been total
and it has assumed the responsibility for providing certain covers. This has been case in areas
such unemployment, sickness and widows benefits; the state carries the risk under the National
Schemes.
END OF THE COURSE
GOOD LUCK!!!

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RISK MANAGEMENT & INSURANCE

CHAPTER 01: RISK & RELATED TOPICS

CHAPTER ONE {1}

1.1. Definition of Risk

 Risk is the Chance of Loss

 Risk is the Possibility of Loss

 Risk is the Uncertainty of Loss

1.2. Risk VS. Uncertainty

Level of Uncertainty Characteristics Examples

Level 1 Outcomes are identified Games of chance, Cards,

Level 2 Outcomes are identified Fire, automobile accident,

o Uncertainty is the doubt that a person is aware of it or conscious as to the existence of

1.3. Risk & Probability

Risk is a characteristics of the entire probability distribution, where as there is a separate

ii. Subjective Probability:

Probability distinguished from Risk:

1.4. Risk, Peril & Hazard

 Moral hazard is dishonesty or character defects in an individual that increase the

1.5. Classification of Risk

1) Financial Vs Non Financial Risks

2) Static and Dynamic Risks

3) Pure Risks Vs Speculative Risks

In general, earning power is subject to four perils:

4) Risk Arising from the Failure Others

Distinguish between pure and speculative risks:

4) Subjective Versus Objective risks

5) Fundamental Risk Versus Particular Risks

ii. Particular Risk:

------------- THE END OF CH01 ------------

CHAPTER TWO {2}

2.1. Definition of Risk Management

2.2. Objectives of Risk Management

 Social Responsibility: Finally, the objective of social responsibility is to minimize

2.3. Steps in Risk Management Process

2.3.1. Risk Identification:

Loss Exposures (Sources of Risks):

B. Business Income Loss Exposures:

d. Contingent Business income losses.

C. Human Resources Exposures:

F. Foreign Loss Exposures:

 Techniques for Identifying Risks:

A second type of checklists focuses on a specific category of exposure. The questions

v. Interactions with other Departments: Frequent interactions with other departments

vi. Interactions with Outside Suppliers and Professional Organizations: In addition to

2.3.2. Risk Measurement (Risk Evaluation)

2.3.3. Tools of Risk Management

In contrast to frequency reduction, consider an auto manufacturer having airbags installed

 Separation involves the reduction of maximum probable loss associated with

 Duplication is a very similar technique, in which spare parts or supplies are

ii. Timing of Loss Control:

 Second Timing Categories – Concurrent Activities

Post – Loss Activities.

Potential Benefits of Loss Control:

b. Intermediate Form: A second type of hold-harmless agreement is the intermediate

C. Insurance: The most widely used form of risk transfer is insurance.

D. Hedging: involves the transfer of speculative risk. It is a business transaction in which

2.3.4. Risk Management or Risk Administration Matrix

Type of Loss Loss Loss Appropriate Risk

------------- THE END OF CH02 ------------

CHAPTER THREE {3}

3.2. Basic Characteristics of Insurance

In addition, by pooling or combining the loss experience of a large number of exposure

3.3. Fundamentals of Insurable Risk