CHAPTER - 1

RISK AND RELATED TOPICS

Introduction:
The risk is concerned with physical and financial well-being. The people are living with some
threatening like fire, flood, earthquake, accident, terrorist attack, etc. That shows certain risks are
present in our society. We can say, we are living in a risky world. In the present day context,
individuals have a strong desire for financial security and protection against those events that
threaten their financial security. Financial security can be threatened by numerous factors such
as;
- If the family head is killed in an accident
- Destruction of property by fire, floods, earth quakes and other natural factors.
- Infected by serious diseases such as Cancer, Heart disease, HIV etc.
Thus, it is apparent that certain factors can threaten the financial security of individuals and
their families.

1.1. Risk definition:

There is no single definition of risk. Economist, behavioral scientists and risk theorists have
their own concept of risk. However they have common elements in definition are
indeterminacy and loss. Or Risk could be also defined as a Probability or threat of a
damage, injury, liability, loss, or other negative occurrence, caused by external or
internal (Degree to which people, property, resources, systems, and cultural, economic,
environmental, and social activity is susceptible to harm, degradation, or destruction on being
exposed to a hostile agent or factor.) and which may be neutralized through pre-mediated
action. On the other hand Risk is uncertainty regarding loss. Or Risk is a condition in
which there is a probability of an adverse deviation from desired outcome that is expected
or hopped for. It is the probability that this hope will not be met that constitutes risk.
- Risk is uncertainty concerning the occurrence of a loss or events which might produce a
loss (an event)
-Risk is unpredictable event the tendency that the actual results may differ from the
predicted ones.
The risk may be defined in two way namely Objective risk and Subjective risk.
  Objective risk is defined as the relative variation of actual loss from the expected
loss.
For example, assume that a man has 1000 houses insured over a long period of time, and on
average10 houses burn each year. However, we cannot expect 10 houses to burn each year
exactly. In some years, 8 houses may burn, while other years 12 houses may burn. Thus,
there is a variation of 2 houses from the expected number of 10. This relative variation of an
actual loss from expected loss is known as objective risk.

 Subjective risk is defined as uncertainty based on a person’s mental condition or

state of mind.
For example, a person who has drunk more in the bar may attempt to drive home on
his own. Here, he may uncertain whether he will arrive home safely without any
accident due to drunken driving. This mental uncertainty is called subjective risk
1.2. Risk Vs Uncertainty
Uncertainty:
It is the situation where:
 the order or nature of things is unknown,
 the consequences, degree, or magnitude of situation, conditions, or events is
unpredictable,
 Believable probabilities to possible outcomes cannot be assigned.
The dictionary meaning of risk is “the possibility of meeting danger or suffering harm or
loss”. The dictionary meaning of uncertainty is “the state of being uncertain”. Here, uncertain
means “feeling suspicion about”.
Thus, uncertainty of meeting with a loss or damage is known as risk.
Although risk is defined as uncertainty, employees in the insurance industry often use the
term risk to identify the property or life being insured.
The term uncertainty often used in connection with the term risk and sometimes used
interchangeably. Therefore it is important to explain the relationship between the term risk
and uncertainty.
 Uncertainty is refers to a state of mind characterized by doubt, based on a lack of
knowledge about what will or will not happen in the future.
 It is simply psychological reaction to the absence of knowledge about the future.
  Uncertainty is a doubt a person has concerning his/ her ability to predict which of the
many possible outcomes will occur.
 It is the person’s conscious or awareness of the risk in a given situation.
 It depends on the person’s estimated risk what that person believes to be the state of
the world and the confidence he or she has in this belief.
 Uncertainty - being unsettled or in doubt or dependent on chance or the state of being
unsure of something.
Although too much uncertainty is undesirable, manageable uncertainty provides the
freedom to make creative decisions
1.3. Risk and probability

Probability refers to the long run chance of occurrence.

Probability may or may not relate to loss but risk is necessary related to loss.
Probability is classified in to two:
 Objective probability
 Subjective probability
Objective probability refers to the long run relative frequency of an event based on the
assumption of an infinite number of observations and no change in the fundamental
conditions. Objective probabilities can be determined in two ways. I.e. deductive (priori
or presupposed by experience) and inductive reasoning (e.g. the probability that a person
age 21 will die before 26 cannot be logically deduced. But by careful analysis of past
mortality experience, life insurance can estimate the probability of death and sell a five–year
term insurance policy issued at age 21.

Subjective probability: it is the individual’s personal estimate of the chance of loss.

Example people who buy lottery ticket on their birthday may believe lucky day and
overestimate the small chance of winning. A wide variety of factors can influence subjective
probability including a person’s age, intelligence, education and use of alcohol.

1.4. Risk, peril ,hazard Frequency and Severity

Usually risk is expressed in terms of :
Frequency - probability of occurrence
Severity / consequences – financial loss
Peril- the prime cause of the event -Immediate cause of losses or the event which bring
about losses.
Hazards – A hazard is a condition that creates or increases the chance of loss

 Peril: it is defined as the source of loss. It is the contingency (incident) that may
cause loss. E.g. The peril of fire or cyclone or frozen rain or theft. Each of these is the
cause of the loss that occurs. If your organization is burns because of fire the peril
or the cause of loss is might be improper installation of electrical system. If your car
damaged in a collision with another car, the break system is fall is the peril or the
cause of loss.
 Hazard: it is the condition that may create or increase the chance of loss arising from
given peril. A hazard is a condition that introduces or increases the probability of
loss from peril. E.g. one of the perils that can cause loss to a car is collision. A
condition that makes the occurrence of collisions more likely is traffic congestion or
unsafe roads. The insecure road (unsafe) is the hazard and the collision the peril.
Storage of gasoline in a kitchen is another example of hazards. The storage of
gasoline generally will not cause a loss. The gasoline, however, will make fire losses.
Poor lighting in a crime-prone area is a hazard, in that theft losses may be more
frequent than would be the case if the better lighting were available. The poor
lighting by itself would not cause the loss. But to the extent that it makes theft more
frequent, it is a hazard. It is possible for something to be both peril and hazard. E.g.
sickness is peril causing economic loss, but it is also a hazard that increases the
chance of loss from the peril of premature death.
There are three basic types of hazards:
 Physical hazard
 Moral hazard
 Morale Hazard
Physical hazard: it is the physical condition that increases the chance of loss. Or it is a
condition shooting from the physical characteristics of an object that increases the probability
and severity of loss from given perils. It includes: phenomena as the existence of dry forests
(hazard for fire), earth faults (hazard for earth quakes, defecting wiring in a building that
increases the chance of fire, defective lock on a door that increases the chance of theft.
Physical hazards may or may not be within human control.
 Moral hazard: It is dishonesty or character defects in an individual that increase the
frequency or severity of loss. It refers to the increase in the probability of loss that result from
dishonest tendencies in the character of the insured person. Dishonest person may
intentionally cause the loss or may overstate the amount of a loss in trying to collect more
than the amount he or she entitled. Examples of moral hazards are:
 Faking an accident to collect the insurance
 Submitting a fraudulent claim
 Inflating the amount of claim
 Intentionally burning unsold merchandise that is insured
Morale hazard: It is carelessness to a loss because of the existence of insurance. When
people have purchased insurance they may have a more careless attitude toward preventing
losses. Example morale hazards are:
 Leaving car keys in the ignition of unlocked car
 Leaving door unlock
 Changing line of traffic suddenly on a congested road without signing
 Careless acts
1.5. Classification of risk
Risk may be classified in many ways. The most common categories are:
 Fundamental vs. Particular
 Dynamic vs. Static
 Pure vs. Speculative
 Financial and non-financial risks

Fundamental vs. Particular
Fundamental risk is a type of risk that affects a large number of people in an economy.
Earthquake and war are the examples of those. If it is originated from nature of society,
namely act of war and unemployment risk, then it is not insurable.

On the other hand, particular risk is a risk that affect only individual. For instance, fire,
robberies and thefts. These risks are all insurable.

Dynamic vs. Static
Risks can also be classified by dynamic and static.
Dynamic risk occurs due to changes in economy that causes financial loss to certain people.
It exists as a result of adjustment to misallocation of resources in the economy. In modern
times, one of the clearer examples is the rapid change in information technology industry.
Many companies were made victims while others were emerged as new successes.

Static risk, on the other hand, happens even though there are no changes taking place.
During market boom or collapse, there are people making losses. These types of losses are
due to natural perils like earthquakes, cyclone (storm) or moral hazards like cheat. Static risk
brings no benefits to the society, only pure losses.

Pure and Speculative
Risks can also be categorized as pure or speculative. In pure risk, there is either a possible
loss or no loss. In contrast, there are possibilities of gain or loss in speculative risk. Pure risk
can be insured while speculative risk can't. However, the pure risk consequences of
speculative risk are insurable. For instance, decision to manufacture a brand new product
involves speculative risk, either gaining from the product or making losses. So, it is not
insurable.

There are basically 3 types of pure risks that concern an individual

Types of Pure Risks
 Personal Risks
 Property Risks
 Liability Risks

Personal Risks
They earn losses like loss of income, additional expenses and devaluation (depreciation )of
property. There are 4 risk factors affecting this:

 Premature death. This is death of a breadwinner who leaves behind financial

responsibilities.

 Old age / retirement. The risk of being retired is not sufficient savings to support
retirement years.
  . Health crisis. Individual with health problem may face potential loss of income and
increase in medical expenditures.

 Unemployment. Jobless individual may have to live on their savings. If his savings is
used up, the bigger crisis is awaiting.

Property Risks
It means the possibility of damage or loss to the property owned due to some causes. There
are two types of losses involved.

 Direct loss which means financial loss as a result of property damage.

 Consequential loss which means financial loss due to the happenings of direct loss of
the property. For instance, a shop lot which is burnt down may incur repair costs as
the direct loss. The consequential loss is being unable to run the business to generate
income.
Liability Risks
A person is legally liable to his wrong doings which cause damages to third party's body,
reputation or property. you can be legally sued (charge) and the most horrible thing is there is
no maximum in the compensation amount if you are found guilty.

Knowing how the risks are classified and the types of pure risks an individual is exposed to
will surely give you a fundamental on the risk topics and prepare yourself to further acquire
the knowledge of how to manage risk.

Financial and non-financial risk:

In this context the term risk includes all situations in which there is an exposure to danger.
Some cases this danger involves financial loss, while in other it does n
 CHAPTER -2
Risk Management
2.1. Introduction
In the previous section we have identified several types of pure risks that affect individuals
and business. After sources of risks are identified and measured, a decision can be made as
to know how the risk should be handled. The process used to systematically mange pure risk
exposures are known as risk management.
Definition of risk management
Risk management is defined as a systematic process for the identification and evaluation of
pure loss exposures faced by an organization or individual and for the selection and
implementation of the most appropriate techniques for treating such exposures. As a general
rule, the risk manager is concerned with only management of pure risks, not speculative
risks.
2.2. Objective of risk management
Risk management has several important objectives that can be classified into two categories:
 Pre loss objective
 Post loss objective
Pre loss objective are;
 To prepare for the potential loss in the most economical
 Reduction of anxiety (worry )
 Meeting external obligation (duty )
Post loss objective
 Survival of the organization
 Continuity of operation
 Stability of earning
 Continued growth
 Social responsibility
An organization has many risk management objective prior to the occurrence of a loss.
The most important of such objective are as follows:
1. The first objective is that the firm should prepare for potential losses in the most
economical possible way. This involves as analysis of safety program expenses,
insurance premiums and the cost associated with the different techniques of handling
losses.
2. The second objective is the reduction of anxiety. In an organization, certain loss
exposures can be cause greater worry and fear for the risk manager. For instance, a
threat of court case from a defective product can cause greater anxiety than a
possible small loss from minor fire. But the risk manager wants to minimize the
anxiety and fear associated with such loss exposures.
3. The third objective is to meet any externally imposed (forced) obligations. This
means that the firm must meet certain obligations imposed on it by the outsiders. For
instance, government regulations may require an organization to install safety
devices to protect workers from harm. Thus, the risk manager is expected to see that
these externally imposed obligations are met properly.
Post loss objectives
Post loss objectives are those which operate after the occurrence of a loss. They are described
as follows:
1. The first post loss objective is survival of the organization. It means that after a loss
occurs, the firms can at least restart partial operation within reasonable time period.
2. The second post loss objective is to continue operating. For some organizations, the
ability to operate after a severe loss is an extremely important objective. Especially,
for public utility firms such as bank and dairies (farms for milk production) they must
continue to provide service. Otherwise, they may loss their customers to competitors.
3. Stability of earning is the third post loss objective. The firm wants to maintain its
earnings per share after a loss occurs. This objective is closely related to the objective
of continued operations. Because earning per share can be maintained only if the firm
continues to operate.
4. Another important post loss objective is continued growth of the organization. An
organization may grow by developing new product and markets. Therefore, the risk
manager must consider the impact that a loss will have on the organization’s ability to
grow.
5. The fifth and the final post loss objective is the social responsibility to minimize
the impact that a loss has on the persons and society. A server loss can adversely
affect the employees, customer’s suppliers, creditors and the community in general.
The risk manger role is to minimize the impact of loss on other persons.
Therefore, a prudent (careful) risk manager must keep these objectives in mind while
handling and managing the risk.
1.6. Step in Risk Management Process
The concept behind a risk management process is extremely simple. It is the process of
anticipating and analyzing risks and coming up with effective and efficient ways of
managing as well as eradicate them. Here are four different steps that are involved in this
process:
 Risk identification( identify potential loss)
 Risk measurement( to evaluate the potential loss)
 Selection of appropriate risk management tools( handling losses)
 Risk administration( implement and administer the program)
1.6.1. Risk Identification: The first step involves identifying risks. Certain risks could be
quite obvious whereas a few others may need a certain amount of anticipation. There
could be various types of risks such as:
 business risks
 financial risks
 commercial market-related risks
 technology risks
 short term risks, long terms risks
 Personal risks, etc.

The most important thing is SWOT (Strengths, Weaknesses, Opportunities and Threats)
analysis. It will give you systematic results which will prove beneficial in risk identification.
Identifying and anticipating risks is extremely important as it sets the stage for all further
action and steps as part of the risk management plan.

A risk manger has several sources of information that can be used to identify major and
minor loss exposures. These are:

1. Physical inspection of company plant and machineries and can identify major loss
exposures.
2. Extensive risk analysis questionnaire can be used to discover hidden loss exposures
that are common to many organizations.
3. Flow charts that show production and delivery processes can reveal production
bottlenecks where a loss can have severe financial consequences to the organization.
4. Financial statement can be used to identify the major assets that must be protected.
5. Historical loss data. Departmental and historical claims data can be invaluable in
identifying major loss exposures.

Risk manager must also be aware of new loss exposures that may be emerging. More recently
misuse of the internet and e-mail transmissions by employees have exposed employers to
potential legal liability because of transmission of pornographic material and theft of
confidential information.

1.6.2. Risk measurement( Evaluating potential losses)

The second step in risk management process is to evaluate and measure the impact of
losses on the firm. This involves estimation of potential loss frequency and severity.

 Loss frequency refers to the possible number of losses that may occur during
some given period of time.
 Loss severity refers to the possible size of loss that may occur.

Once the risk manger 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 potential for bankrupting the firm is much more important than
an exposure with a small loss potential.

While the risk manager must consider both loss frequency and severity, severity is more
important. Therefore, the risk manager must also consider all losses that can result from a
single event. Both the maximum possible loss and maximum probable loss must be
estimated. The maximum possible loss is the worst that could possibly happen to the firm
during its lifetime. The maximum probable loss the worst loss that is likely to happen.
1.6.3. Selection of appropriate risk management tools( handling losses)
The third step is to identify the available tools of risk management. The major tools
of risk management are the following:
 Avoidance
 Loss control
 Retention
 Non-insurance transfer
 Insurance

Avoidance, loss prevention and loss control are called risk control techniques, because they
attempt to reduce the frequency and severity of accidental losses to the firm. Retention,
non-insurance transfer and insurance are called risk financing techniques, because they
provide for the funding of accidental losses after they occur.

Avoidance: it means that a certain loss exposure is never acquired, or an existing loss
exposure is abandoned. For instance, a firm can avoid earthquake loss by not building a
plant in an earthquake prone area. An existing loss exposure may also be abandoned. For
example, a pharmaceutical firm that produces a drug with dangerous side effects may stop
manufacturing that drug.

Advantages of Avoidance

 The chance of loss is reduced to zero. If the loss exposure is not acquired.
 If an existing loss exposure is abandoned, the possibility of loss is either
eliminated or reduced.

Disadvantages of Avoidance

 It may not be possible to avoid all losses. For instance, company cannot avoid the
pre-mature death of a key executive.
 It may not be practical or feasible to avoid losses arising from the production of a
particular drug. However, without any drug production, the firm will not be in
business.

Loss prevention: it aims at reducing the possibility of loss so that the frequency of losses is
reduced. For example:

 Automobile accidents can be reduced if motorists take a safe driving course and
driving defensively.
 A boiler explosion can be prevented by periodic inspection by a safety engineer
 Occupational accidents can be reduced by elimination of unsafe working conditions
and by strong enforcement of safety rules.
 Fire can be prevented by forbidding workers to smoke in an area where highly
flammable materials are being used.

Loss control: it is another method of handling loss in a risk management program. Loss
control activities are designed to reduce both the frequency and severity of losses. Loss
control deals with an exposure that the firm does not wish to abandon. The purpose of loss
control activities is to change the characteristics of the exposure so that it is more acceptable
to the firm. The firm wishes to keep the exposure but wants to reduce the frequency and
severity of losses. This is because avoiding loss exposure may cause other losses.
The following are the examples that illustrate how loss control measures reduce the
frequency and severity of losses.

Measures that reduce loss frequency

 Quality control checks

 Driver examination
 Strict enforcement of rules
 Improvement in product design

Measures that reduce loss severity

 Installation of an automatic sprinkler( watering spray)

 Installation of robbery alarm system
 Early treatment of injuries
 Rehabilitation of injured workers

Retention: retention means that the firm retains part or all of the losses that result from a
given loss exposure. It can be effectively used when three conditions exist. These are;

 No other method of treatment is available. Insurers may be unwilling to write a

certain type of coverage. Non-insurance transfers may not be available. In addition,
although loss control can reduce the frequency of loss, all losses cannot be
eliminated. In these cases, retention is a residual (outstanding) method. If the loss
exposure cannot be insured or transferred, and then it must be retained.
 The worst possible loss is not serious. For example, physical damage losses to
automobiles in a large firm’s fleet will not cause bankrupts the firm.
 Losses are highly predicable. Retention can be effectively used for workers
composition claims, physical damage losses to automobiles, etc. Based on past
experience, the risk manger can estimate a probable range of frequency and severity
of actual losses.

Advantages of retention
 The firm can save money in the long run if its actual losses are less than the loss
allowance in the insurer’s premium.
 The services provided 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, etc.
 Since the risk exposure is retained, there may be greater care for loss prevention.
 Cash flow may be increased since the firm can use the funds that normally would be
held by the insurer.
Disadvantages of retention
 The losses retained by the firm may be greater than the loss allowance in the
insurance premium that is saved by not purchasing the insurance.
 Actually, expenses may be higher as the firm may have to hire outside experts such
as safety engineers. Thus, insurers may be able to provide loss control services less
expensively.
 Income taxes may also be higher. The premiums and paid to an insurer are income-
tax deductible. However, if retention is used, only the amounts actually paid out for
losses are deductable. Contributions to a funded reserve are not income tax
deductable.

Non-insurance transfers

Non-insurance transfers are another method of handling losses. Non-insurance transfers

are methods other than insurance by which a pure risk and its potential financial
consequences are transferred to another party. Examples of non-insurance transfers
include contracts, leases and hold-harmless agreements. For example, company’s
contract with a construction firm to build a new plant can specify that the construction
firm is responsible for any damage to the plant which it is being built.

A firm’s computer lease can specify that maintenance, repairs and any physical damage
loss to the computer are the responsibility of the computer firm. Otherwise, a firm may
insert a hold-harmless cause in a contract, by which one party assumes legal liability on
behalf of another party. Thus, publishing firm may insert a hold-harmless clause in a
contract, by which the author and not the publisher is held legally liable if anybody sued
the publisher.
 Advantages of Non-insurance Transfers:

1. The risk manger can transfer some potential losses that are not commercially
insurable.
2. Non-insurance transfers often cost less than insurance.
3. The potential loss may be shifted to somebody who is in a better position to
exercise loss control.

Disadvantages of Non-insurance Transfers:

1. The transfer of potential loss would become impossible, if the contract language is
ambiguous.
2. If the party to whom the potential loss is transferred is unable to pay the loss, the
firm is still responsible for the claim.
3. Non-insurance Transfers may not always reduce insurance costs since an insurer
may not give credit for transfers.

Insurance:

Insurance is also used in a risk management program. Insurance is appropriate for loss
exposures that have a low probability of loss but the severity of loss is high. If the risk
manager uses insurance to treat certain loss exposures, five key areas must be
emphasized. They are as follows:

1. Selection of insurance coverage

2. Selection of insurer
3. Negotiation of terms
4. Dissemination of information concerning insurance coverage
5. Periodic review of the insurance program.
1. Selection of insurance coverage’s

The risk manger must select the insurance coverage needed. Since there may not be enough
money in the risk management budget to insure all possible losses, the need for insurance can
be divided into three categories.
  Essential insurance: Includes that coverage required by law or by contract, such as
workers compensation insurance. It also includes those coverage that will protect the
firm against a loss that threats the firm’s survival.
 Desirable insurance: It is protection against losses that may cause the firm financial
difficulty, but not bankruptcy.
 Available insurance: It is coverage for slight losses that would merely inconvenience
the firm.
2. Selection of an insurer

The next step is that the risk manger must select an insurer or several insurers. Here,
several important factors are to be considered by risk manger. These include the
following;

 Financial strength of the insurer

 Risk management services provided by the insurer
 The cost and term of protection.
3. Negotiation of terms: After the insurer is selected, the term of insurance contract
must be negotiated. If printed polices, endorsement and forms all used. The risk
manager and insurer must agree on the documents that will form the basis of the
contract. If a specially modified manuscript policy is written for the firm, the
language and meaning of the contractual provisions must be clear to both parties. If
the firm is large, the premiums are negotiable between the firm and insurer.
4. Dissemination of information concerning insurance coverage’s: Information
concerning insurance coverage must be given to others in the firm. The firm’s
employees must be informed about the insurance coverage, the record that must be
kept, the risk management services that the insurer will provide, etc.
5. Periodic review of the insurance program: the entire process of obtaining
insurance must be evaluated periodically. This involves an analysis of agent and
broker relationships, coverage needed, cost of insurance, quality of loss control
services provided, whether claims are paid on time, etc.

Advantages of insurance:
  The firm will be indemnified after a loss occurs. Thus, the firm can continue to
operate.
 Uncertainty is reduced. Thus, worry and fear are reduced for the mangers and
employees, which should improve their productivity.
 Insurance premium are income tax deductable as a business expense.
 Insurer can provide valuable risk management services such as loss-control services,
claims adjusting, etc.

Disadvantage of insurance

 The payment of premium is a major cost. Under the retention technique, the premium
could be invested in the business until needed to pay claims, but if insurance is used,
premiums must be paid in advance.
 Considerable time and effort must be spent in negotiating the insurance coverage.
 The risk manger may take less care to loss-control program since he/ she has
insured. But such a negligent (careless) attitude toward loss control could increase the
number of non-insured losses as well.

Selection of Risk Management Tools

Risk management matrix

Type of loss Loss frequency Loss severity Appropriate risk management
Technique
1 Low Low Retention
2 High Low Loss control
3 Low High Insurance
4 High High Avoidance

In determining the appropriate method or methods of handling losses, the above matrix
can be used. It classifies the various loss exposures according to frequency and severity.

The first loss exposure is characterized by both low frequency and low severity of loss.
One example of this type of exposure would be the potential theft of an office secretary’s
note pad. This type of exposure can be best handled by retention, since the losses occur is
infrequently and when it occurs it does not cause financial harm.
 The second type of exposure is more serious. Losses occur frequently, but severity is
relatively low. Example of this type of exposure includes physical damage losses to
automobiles, shoplifting and food spoilage. Loss control should be used here to reduce
the frequency of losses. In addition, since losses occur regularly and are predictable, the
retention technique can also be used.

The third types of exposure can be met by insurance. Insurance is best suited for low
frequency, high severity losses. High severity means that a catastrophic potential is
present, while a low probability of loss indicates that the purchase of insurance is
economically feasible. Examples include fires, explosion and other natural disasters. Here
the risk manger could also use a combination of retention and insurance to deal with these
exposures.

The fourth and the most serious type of exposure is characterized by both high
frequency and severity. This kind of risk exposure is best handled by avoidance. For
example, if a person has drunken and if he attempts to drive home in that drunken stage,
the chance of meeting with an accident is more. This loss exposure can be avoided by not
driving at the drunken stage or having a driver to drive his car.

Risk Administration:

The next and final step in risk management process is implementation and
administration of the risk management program. It involves three important
components:

1. Risk management policy statement

2. Cooperation with other department
3. Periodic review and evaluation
Risk management policy statement: A risk management policy statement is necessary in
order to have an effective risk management program. This statement outlines the risk
management objectives of the firm, as well as company policy with respect to the treatment
of loss exposures. It also educates top level executives in regard to the risk management
process and gives the risk manager greater authority in the firm.
Cooperation with other department: the risk manager has to work in cooperation with
other functional departments in the firm. It will facilitate to identify pure loss exposures and
methods of treating these exposures. The accounting department can adopt internal
accounting controls to reduce employee’s misuse and theft of cash. On the other hand, the
finance department can provide information showing how losses can disrupt profits and
cash. Also the marketing department can prevent liability suits by ensuring accurate
packaging. Besides, safe distribution procedures can prevent accidents. Further, the
production department has to ensure quality control and effective safety programs in the
plant can reduce injuries and accidents. Finally, the personnel department may be possible for
employee benefit program, pension program and safety program.

Periodic review and evaluation: the risk management program must be periodically
reviewed and evaluated to see whether the objectives are being attained or not.
Especially, risk management costs, safety programs and loss preventive programs
must be carefully monitored. Loss records must also be examined to detect any changes
in frequency and severity. Finally, the risk manager must determine whether the firm’s
overall risk management policies are being carried out, and whether the risk manger is
receiving the total cooperation of the other departments in carrying out the risk
management functions.
TYPE OF RISKS
1. Property loss exposures
- Building, plants, other structures
- Furniture, equipment, supplies
- Electronic data processing (EDP) equipment; computer software
- Inventory
- Accounts receivable, valuable papers and records
- Company planes, boats, mobile equipment
2. Liability loss exposures
- Defective products
- Environmental pollution (land, water, air, noise)
- Sexual harassment of employees, discrimination against employees, wrongful
termination
- Premises and general liability loss exposures
- Liability arising from company vehicles
- Directors' and officers' liability suits
3. Business income loss exposures
- Loss of income from a covered loss
- Continuing expenses after a loss
- Extra expenses
- Contingent business income losses
4. Human resources loss exposures
- Death or disability of key employees
- Retirement or unemployment
- Job-related injuries or disease experienced by workers
5. Crime loss exposures
- robberies, burglaries
- Employee theft and dishonesty
- Fraud and embezzlement
- Internet and computer crime exposures
6. employee benefit loss exposures
- Failure to comply with government regulations
- Violation of fiduciary responsibilities
- Group life and health and retirement plan exposures
- Failure to pay promised benefits
7. Foreign loss exposures
- Acts of terrorism
- Foreign currency risks
- Kidnapping of key personnel
- Political risks
 CHAPTER -3
INSURANCE
Introductions
Insurance  is  an  important  method  of  transferring  pure  loss  exposures  to  an  entity 
better positioned  to  handle  these  risks.  But  what  is  insurance  and  how  does  insurance 
work?  This chapter analyze  the  insurance  mechanism.  You  will  learn  the  important 
characteristics  of insurance and what conditions must be present for arisk to be privately
insurable. Although  insurance  provides  many  benefits  to society, there are some costs
associated with the use of insurance. These costs and benefits are discussed in this chapter.

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. For example,  from  an  economic  viewpoint,  insurance  is  a system  for 
reducing  financial  risk  by transferring  it  from  a  policy  owner  to  an  insurer.  The 
social  aspect  of  insurance  involves  the collective bearing of losses through contributions 
by all members of a group to pay for losses suffered  by  some  group  members. 
From business  point of  view,  insurance  is  a  financial arrangement that redistributes the
costs of unexpected losses. Insurance involves the transfer of potential losses to an insurance
pool, the pool combines all the potential losses and then transfers the cost of the predicted
losses back to those exposed. Thus, insurance involves the transfer of loss exposures to an
insurance pool, and redistribution of losses among the members of the pool.

From  a  legal  standpoint,  an  insurance  contract  (policy)  transfers  a  risk,  for  a  premium
(consideration),  from  one  party  (the  policy  owner)  to  another  party  (the  insurer).  It  is
a contractual arrangement in which the insurer agrees to pay a predetermined sum to a
beneficiary in the event of the insured’s death. By virtue of a legally binding contract, the
possibility of an unknown  large  financial  loss  is  exchanged  for  a  comparatively  small 
certain  payment.  This contract is not a  guarantee  against a loss occurring, but a method of 
ensuring that payment is made for a loss that does occur.

According  to  the  commission  on  insurance  terminology  of  the  American  risk  and 
insurance association  insurance  is  the  pooling  of  fortuitous  losses by  transfer  of  such 
risks  to  insurers, who  agree  to  indemnify  insured  for  such  losses,  to  provide  other 
pecuniary  benefits  on  their occurrence, or to render services connected with the risk. A
promise of compensation for specific potential future losses in exchange for a periodic 
payment. Insurance is designed to protect the financial  well-being  of  an  individual, 
company  or  other  entity  in  the  case  of  unexpected  loss. Agreeing  to  the  terms  of  an 
insurance  policy  creates  a  contract  between  the  insured  and  the insurer. In exchange for
payments from the insured  (called premiums), the insurer agrees to pay the policy holder a
sum of money upon the occurrence of a specific event.

Illustration

Suppose Ethiopian  Insurance Corporation has sold 500,000 fire insurance policies, through
its various branches i.e., policies that cover losses related to residential buildings so that the
insurer will have to pay compensation to the insured or the beneficiary of the policy in case
where such property is devastated by fire or lightening. The money collected from the sale of
these policies form  the  pool  out  of  which  compensation  shall  be  paid  to  those  persons 
who  have  suffered financial loss because of damage to the insured house. Let us say that in
the given financial year 10,000 policyholders have sustained financial losses /or lost their
properties because of various perils  which  are  covered  by  the  policy.  So,  the  insurer 
according  to  the  obligation  it  has undertaken pays compensation to these policy holders
out of the pool mentioned above, i.e., the price collected by the insurer from the sale of the
policies (premium). In other words this means that all 500,000 policy holders who have paid
the premium have contributed to the compensation paid  to  those  who  have  sustained 
losses.  This  also  means  that,  the  insurer  has  distributed  the losses sustained by the
10,000 policyholders among  the remaining 490,000 policyholders whose properties were not
damaged or destroyed in the given year.

3.2 Basic Characteristics of Insurance

Insurance  has  a  number  of  distinct  characteristics. These  characteristics  include: 

pooling  of losses, payment of fortuitous losses, risk transfer, and indemnification of losses.
Pooling of loss

Insurance is based on a mechanism called risk pooling, or a group sharing of losses. Pooling
is the spreading of losses incurred by the few over the entire group, so that in the process,
average loss is substituted for actual loss. In addition, pooling involves the grouping of large
number of exposure units so that the law of large number can operate to provide a 
substantially  accurate prediction of future losses. Ideally, there should be a large number of
similar, but not necessarily identical, exposure units that are subject to the same perils. People
exposed to a risk agree to share losses on an equitable basis. They transfer the economic risk
of loss to an insurance company. Insurance collects and pools the premiums of thousands of
people, spreading the risk of losses across the entire pool. By carefully calculating the
probability of losses that will be sustained by the members of  the pool, insurance companies
can equitably (fairly) spread the cost of the losses to all the members. The risk of loss is
transferred from one to many and shared by all insured’s in the pool. Each person pays a
premium that is measured to be fair to them and to all based on the risk they impose on the
company and the pool (each class of policies should pay its own costs). If all insured’s
contribute a fair amount to the loss of fund held by the insurance company, there will be
sufficient dollars in the fund to pay the loss benefits of those insured’s that exposed for loss
in the coming year.

Individually, we do not  know when  we  will exposed for  accident or loss, but statistically,
the insurer can predict with great accuracy the number  of individuals that will incurred a loss
in a large  group  of  individuals.  The  insurance  company  has  taken  uncertainty  on  any 
individual’s part,  and  turned  it  into  a  certainty  on  their  part. Thus  pooling  implies: 
Sharing  of  loss  by  the entire  group  and  prediction  of  future  losses  with  some 
accuracy  based  on  the  law  of  large number.

Examples: The simplest illustration of risk pooling involves  providing life insurance for one
year, with all members of the group the same age and possessing similar prospects for
longevity. The members of this group agree that a specified sum, such as $100,000, will be
paid to the beneficiaries of those members who die during the  year, the cost of  the payments
being shared equally by the members of the group. In its simplest form, this arrangement
might involve an assessment upon each member in the appropriate amount as each death
occurs. In a group of 1,000 persons, each death would produce an assessment of $100 per
member. Among a group of 10,000 males aged 35,  21  of  them  could  be  expected  to  die 
within a  year,  according  to  the  1980  Commissioners Standard  Ordinary  Mortality  Table 
(more  on  this  later).  If  expenses  of  operation  are  ignored, cumulative assessments of
Birr210 per person would provide the funds for payment of $ 100,000 to  the  beneficiary  of 
each  of  the  21  deceased  persons.  Larger  death  payments  would  produce proportionately
larger assessments based on the rate of $2.10 per $ 1000 of benefit.

Payment of fortuitous losses

The second characteristic of insurance is the payment of fortuitous losses. A fortuitous loss is

one that is unforeseen and unexpected and occurs as a result of chance. In other words, the
loss must be accidental. For example, a person may slip on an icy side walk and break his or
her leg. The loss would be fortuitous.

Risk Transfer

Risk  transfer  is  another  essential  future  of  insurance.  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  view  point  of  individual,  pure  risk 
that are typically transferred to insurer include, the risk of premature death, poor health,
disability, destruction and theft of property and personal liability lawsuits

Indemnification

The last characteristic of insurance is  indemnification. It means that the insured is restored to
his or her approximate financial position prior to the  occurrence of the loss. Thus, if the
home of insured  burns  in  fire,  homeowner  policy  will  indemnify  or  restore  the  insured 
to  previous positions. If you are sued because of the negligent of an automobile, your auto
liability insurance policy will pay those sums that you are legally obliged 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

Insurer  normally  insures  only  pure  risk.   However  not  all  pure  risks  are  insurable. 
Certain requirements usually must be fulfilled before pure  risk can be privately insured.
From the view point of insurer, there is ideally six requirements of an insurable risks. These
are:
 1. There must be a large number of exposure units.
2. The loss must be accidental and unintentional.
3. The loss must be determinable and measurable.
4. The loss should not be catastrophic.
5. The chance of loss must be calculable.
6. The premium must be economically feasible.

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  surrounding dwellings in a city can be grouped together for
purposes of providing property insurance on the dwellings. The purpose of this first
requirement isto 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 be spread over all insured’s in the underwriting class.
For  a  plan  of  insurance  to  function,  the  pricing  method  needs  to  measure  the  risk  of 
loss  and determine the amount to be contributed to the pool by each participant. The theory
of probability provides such a scientific measurement. 

Insurance  relies  on  the  law  of  large  numbers  to  minimize  the  speculative  element 
and  reduce volatile fluctuations in year-to-year losses. The greater the number of exposures
(lives insured) to a peril (cause of loss/death), the less the observed loss experience (actual
results) will deviate from  expected  loss  experience  (probabilities).  Uncertainty 
diminishes  and  predictability increases as the number of exposure units increases. It would
be a gamble to insure one life, but insuring 500,000 similar persons will result in death rates
that will very little from the expected.

Accidental and Unintentional loss: A second  requirement  is  that  the  loss  should  be 
accidental  and  unintentional;  ideally,  the loss should be fortuitous and outside the insured's
control. Thus, if an individual deliberately causes a loss, he or she should not be indemnified
for the loss. The requirement of an accidental and unintentional loss is necessary for two
reasons. First, if intentional  losses  were  paid,  moral  hazard  would  be substantially 
increased,  and  premiums would  rise  as  a  result.  The substantial increase in premiums
could  result  in  relatively  fewer persons purchasing the insurance, and the insurer might not
have a sufficient number of exposure units to predict future losses. The second reason is the
loss should be accidental since the law of large number is based on the random occurrence of
events. A deliberately caused loss is not random event because the insured known when the
loss occur. Thus, prediction of future experience may be highly in accurate if a large number
of intentional or random loss occur.

Determinable and Measurable Loss: The third requirement is that the loss should be both
determinable and measureable. This means 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 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 a monthly benefit to the disabled promises to pay a monthly  benefit to the disabled
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.  Sickness and disability are highly subjective and
the same event can affect two persons quite differently.

For example, two accountants who are insured under separate disability-income contracts
may be injured in an auto accident, and both may be classified as totally disabled. One 
accountant, however, may be stronger  willed and more determined to return to work.  If 
that  accountant undergoes  rehabilitation  and  returns to work, the disability-income 
benefits  will terminate. Meanwhile, the other accountant would still continue to receive
disability-income benefits according to the terms of the policy. In short, it is difficult to
determine when a person is actuallydisabled. However, all losses ideally should be both
determinable and measurable. The basic purpose of this requirement is to enable insurer to
determine if the loss is covered under  the  policy,  and  if  it  is covered,  how  much should
be paid. 

Catastrophic Loss: The fourth requirement is that ideally the loss should not be catastrophic.
This means that a 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
become unworkable. Premiums must be increased to prohibitive levels, and the insurance 
technique is no longer a viable arrangement by which losses of the few are spread over the
entire group. Insurers ideally wish to avoid all catastrophic losses. In reality, however, this is 
impossible, because catastrophic losses periodically result from 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  problem  of  a  catastrophic  loss.  First,
reinsurance  can  be  used  by  which  insurance  companies  are  indemnified  by  reinsurers 
for catastrophic  losses. Reinsurance  is  an  arrangement  by  which  the  primary  insurer 
that  initially writes the insurance transfers to another insurer (called the reinsurer) part or all
of the potential losses associated with such insurance. The reinsurer is then responsible for
the payment of its share of the loss. Second,  insurers  can  avoid  the  concentration  of  risk 
by  dispersing  their  coverage  over a large geographical area. The concentration of loss
exposure in geographical area exposed to frequent floods, earthquakes, hurricanes or other
natural disasters can result in periodic catastrophic loses. If the loss exposures are
geographically dispersed,the possibility of catastrophic loss is reduced.

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 severity of losses is difficult. Thus, without
government assistance, these losses are difficult for private carriers to insure.

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 percent, the
cost of the policy will exceed the amount that the  insurer  must  pay  under  the  contract. 
For  example,  an  insurer  could  issue  a  Birr 1000  life insurance  policy  on  a  man  age 
99,  but  the  pure  premium  would  be  about  Birr  980,  and  an additional amount for
expenses would have to be added. The total premium would exceed the face amount of the
insurance."

Calculation of a proper premium may be difficult because the chance of loss cannot be
accurately estimated. For  example, insurance  that  protects a retailer against loss because of 
a change in consumer tastes, such as a style change,  generally is not available. Accurate loss
data are not  available,  and there is no  accurate  way to  calculate a premium. The premium
charged mayor may not be adequate to pay all losses and expenses. Since private insurers are
in business to  make  a  profit,  certain  risks  are  difficult  to  insure  because  of  the 
possibility  of  substantial losses.

3.4 Insurance and Gambling Compared

Insurance is many times compared to gambling because in both, the payment of money is
linked to the happening of an uncertain event. Some people claim that insurance is a gamble.
Insurance is actually the opposite of gambling. Although insurance is often confused with
gambling, there are differences between insurance and gambling. These are:

 Gambling creates a new speculative risk, while insurance is used for managing an
already existing pure risk. No new risk is created by the insurance transaction.
  Gambling  is  a  win-lose  proposition  because  one  person  wins  while  the  other 
loses. Insurance is a win-win situation because both the insurer and the insured have a
common interest in the prevention of loss. Both parties win if the loss does not occur.
 In the case of gambling, the loss is created intentionally while in the case of insurance
the loss is accidental.
  Gambling  transactions  never  restore  the  losers  to  their  former  financial 
position.  In contrast, if loss occurs, insurance contracts restore the position of the
insured financially in whole or in part

3.5 Insurance and Speculation Compared

Both are similar in that risk is transferred by a contract and no new  risk is created. The main
difference between insurance and speculation lies in the type of that each is designed to
handle, and  in  the  resulting  differences  in  contractual  arrangements.  The  main 
similarity  lies  in  the central  purpose  behind  each  transaction.  However,  there  are  some 
important  differences  exist between  them.  Insurance  transaction  normally  involves  the 
transfer  of  risks that are insurable since the requirements of an insurable risk generally can
be met. While speculation is a technique for handling risks that  are typically uninsurable.
Insurance can reduce the objective  risk of an insurer by application of the law of large
numbers,but speculation only involves transfer of risks and not reduction of risk. The losses
cannot be predicted based on the law of large numbers. 

3.6 Benefits and Cost of Insurance to the Society

Benefits of Insurance to Society

As explained in the previous section, insurance serves as a very useful means of spreading the

effects of personal as well as business risks by way of loss or damage among many. Thus, the

insured  have  a  sense  of  security.   Individuals  who  pay  premium  periodically  out  of 
current income can look forward to an assurance of receiving a fixed amount on retirement or
his family being secured in the event of his death. Businessmen also pay premium for
insurance of risk of loss without constant worry about the possibility of loss or damage.

Insurance  plays  a  significant  role  particularly  in  view  of  the  large-scale  production 
and

distribution  of  goods  in  national  and  international market.   It  is  an  aid  to  both  trading 
and industrial  enterprises,  which  involve  huge  investments  in  properties  and  plants  as 
well  as inventories  of  raw  materials,  components  and  finished  goods.  The  members  of 
business community feel secured by means of insurance as they get assurance that by
contributing a token amount they will be compensated against a loss thatmay take place in
future.

Society is not free from risks and uncertainty.  Insurance is a social device providing 
financial compensation  to  those  who  suffer  from  misfortune.  Such  payment  being 
made  from accumulated contribution of all parties participating in the scheme. Insurance
provides stability, in the society by necessary arrangement of securityagainst loss form
unexpected risks. Society becomes more peaceful and safe by insurance, which  provides
different welfares and financial security against losses from risks. The major benefits of
insurance to society are given below.

Peace of mind: Another  benefit  of  insurance  to  society  is  that  it  decreases  the  worry 
and  fear  of  members  of society regarding the risk of accident and premature death. The
insured replaces the uncertainty of loss with the certainty of a known premium. 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. Similarly,
businessmen who are insured enjoy greater peace of mind because  they  know  are  covered 
if  a  loss  occurs. Thus,  insurance  substitutes  certainty  for uncertainty,  through  the 
pooling  of  groups  of  people  who  share  the  risks  to  which  they  are exposed. Uncertain
risks of individuals are combined, making the possible loss more certain, and providing  a 
financial solution to the problems created by the loss. Small, certain  periodic contributions
(premiums) by the individuals in the  group provide a fund from which those who suffer a
loss are compensated.The certainty of losing the premium replaces the uncertainty of a larger
loss.

Indemnification of losses: The primary objective of insurance is to provide financial 

compensation  to those insured who suffered accidental losses. The essence of insurance is
the principle of indemnity, means that the person who suffers a financial loss is restored to 
his/her approximate financial position prior to the occurrence of the loss. Thus, if your home
burns in fire, a homeowners policy will indemnify you or restore your to previous position.

Loss control: The system of rating, which rewards risk preventionmeasures with lower
premiums, encourages loss  prevention.   Workplaces  implement  health  and  safety 
measures,  drivers  drive  more carefully; homeowners install burglar alarms and smoke
detectors. Society would suffer greater losses if it were not for these measures.

Source of Investment Funds: From  the  national  economic  point  of  view,  insurance
enables  savings  of  individuals  to accumulate  with  the  insurance  companies  by  way  of 
premium  received.   These  funds  are invested in securities issued by big companies as well
as Government.  Individuals who insure their  lives  to  cover  the  risks  of  old  age  and 
death are  induced  to  save  a  part  of  their  current income, which is by itself of great
importance. Insurance is also a source of employment for the people.  The  people  get 
employed  directly  in  its  offices  spread  over  the  country  and  it  also provides
opportunities to the people to earn their livelihood by working as agent of the insurance
companies.

Fewer Burdens to Society: Because insured’s are restored either in part or inwhole after a
loss occurs, they are less likely toapply  for  public  assistance  welfare  benefits,  or  to seek 
financial  assistance  from  relatives  and friends. So other members of the society need not
help the unlucky member even after suffering from loss. If the individuals have not insured
the  risk, the relatives and friends should support him financially, when he becomes unlucky
victim from the risks.

Cost of Insurance to society

No institution can operate without certain costs. These are listed below so that one can obtain
an impartial view of the insurance institution as a social device. The major social costs of
insurance include the following: Cost of doing business, Fraudulent claims and Inflated
claims

Cost of doing Business: The main social cost of insurance lies in the use of scarce of
economic resources land, labor, capital, and organization to operate the business.  In financial
terms, an expense loading must be added to the pure premium to cover the expenses incurred
by insurance companies. An expense loading is the amount needed to pay all expenses,
including commissions, general administrative expenses,  state  premium  taxes,  acquisition 
expenses,  and  an  allowance  for  contingencies  and profit. The cost is justified from the
insured's view point as follows:

 Uncertainty  concerning  the  payment  of  a  covered  loss  is  reduced  because  of
insurance.
 The cost of doing business is not necessarily wasteful, because insurers engage in a
wide variety of loss prevention activities.
 The insurance industry provides jobs to millions ofworkers.

However, because economic resources are used up in providing insurance, a real economic
cost is incurred.

Fraudulent claims: These are the claims made against the losses that one caused
intentionally by people in order to collect on their policies. There always exists moral hazard
in all forms of insurance. Arson losses are on the increase. Fraud and vandalisms are the most
common motives for arson. Fraudulent claims are made against thefts of valuable property,
such as diamond ring or fur coat, and ask for reimbursement. These claims results in higher
premiums to all insured. These social costs fall directly on society.

Inflated claims: It is a situation where, the tendency of the insured to exaggerate the extent
of damages that result from purely unintentional loss occurrences. Examples of inflated
claims include the following.
  Attorney for plaintiffs may seek high liability judgments - Liability insurance
 Physicians may charge above average fees - health insurance
  Disabled persons may malinger to collect disability income benefits for a longer
duration.

These  inflated  claims  must  be  recognized  as  an  important  social  cost  of  insurance. 
Premiums must  be  increased  to  cover  the  losses,  and  disposable  income  that  could  be 
used  for  the consumption of other goods or services is thereby reduced. The social costs of
insurance can be viewed as the sacrifice that society must make to obtain the social benefits
of insurance.