Principles of Insurance And Risk

Management
Imran Yasin (Chartered Insurer)-FCII (UK), ARM
(USA), Masters of Business Economics(PU), MS
Banking & Financial Economics (GCU), CITIP (UK),
PGDAE (PU), DIS (PU) – HEAD OF INSURANCE &
RISK MANAGEMENT (MASTER GROUP OF
INDUSTRIES)
 The Concept of risk
Risk perception
People identify risk according to their own
perception about risk e.g. Probability of failure
or success for a newly opened large general
store.
Activity – Think what is the chance (probability)
of failure or success of a business in Karachi or
Lahore.
 The Concept of risk
Definition of risk
• The possibility of an unfortunate occurrence.
• Doubt concerning the outcome of a situation.
• Unpredictability.
• The possibility of loss.
• The chance of gain.
Elements of uncertainty and unpredictability is
important in order to insure a subject matter.
 The Concept of risk
Many risk may be associated with a subject matter of
insurance e.g. owning a car may depicts the following risks:
• Car will be stolen in future
• Car accident with or without injury to driver
• Injury to others due to car accident
• Damage to car caused by other drivers.
In order to mitigate these above said risk insurance is used.
So, Insurance is a risk transfer mechanism where insurer
receive premium (a small amount) for compensating insured
for the unknown cost of insured risk.
 The Concept of risk
Other meaning of the term ‘ risk’
Peril or contingency that is insured–Fire, theft
etc.
Thing or liability actually insured –
Manufacturer's liability to the public.
For underwriter risk means – Thing insured
(property itself) and Range of contingencies or
scope of cover required.
 The Concept of risk

Attitude to risk:

Risk seeking & Risk averse

Risk neutral
 Risk Management
Definition:
The identification, analysis & economic control
of those risks which can threaten the assets or
earning capacity of an enterprise.
Steps involve in R.M :
Risk identification

Risk analysis–Past data (trend – predict future)

Risk control (Physical & Financial Risk control)

 Types of risk that can be insured
Insurable Risk

Financial

Pure

Particular
 Categories of Risk
Other characteristics of Insurable risk:
Fortuitous or unforeseen Insured event - accidental /
unexpected

Insurable interest – Legal relationship exist between insured

& object or liability that is being insured

Insuring risk must not be against public policy-Crime

insurance.

Homogeneous exposures-similar risks , historical pattern &

trends enable insurer to forecasts (Insurer use law of large no.).
 Insurable & Uninsurable risks
Insurable risks Uninsurable risks
1. Financial 1. Non-financial
2. Pure 2. Speculative
3. Particular 3. Fundamental (generally)
4. Fortuitous event 4. Deliberate act
5. Insurable interest 5. No insurable interest
6. Not against public policy 6. Against public interest
7. Homogeneous exposures 7. One-offs (generally)
 Component of risk

Uncertainty – doubt about future due to incomplete knowledge

Level of risk – Frequency & severity

Peril (Give rise to a loss e.g. lightning) & Hazard (influence the operation
or effect of the peril e.g. High value sports cars, Safari holidays)
 Component of risk

Physical Hazards
• Related to physical characteristics of risks e.g.
construction of property, type of motor car etc.

Moral Hazards
• Arises from attitude & behaviour of the people
e.g. Carelessness, Dishonesty, Social attitude
etc.
 Insurance
Need for Insurance:
Insurance – risk transfer mechanism (Primary
function).
Provide peace of mind – Financial security.
Pooling of risks:
Losses of the few are met by the contributions
of many.
 Professionals in insurance

• Underwriters
• Claims Personnel
• Loss adjusters - Expert in claims processing & independent, professionally
qualified persons appointed by insurance company for claim settlement.
• Loss assessors – Appointed by insured for claim negotiation & paid by
insured.
• Surveyors and those providing forensic services
• Forensic means brings to light in public domain & Expert are employed for
claim investigation i.e. exact cause of loss.
• Surveyor is appointed mostly for risk assessment & its role may also
involve in claims situations e.g. advice on the immediate action necessary
following a loss, recommendations to any underwriting action necessary.
 Professionals in insurance

• Actuaries – Professionally qualified person who applies probability

and statistical theory to problems of insurance, investment,
financial & risk management and demography.
• Risks Managers – Functions or R. managers:
• Risk identification, analysis, economic elimination & control;
• Provide guidance to management on risks;
• Transfer by contract or insurance the identified risks.
• Compliance officer - Report to governing body and ensures that
firm abides by the rules & regulations of FSA.
• Functions of Compliance officer:
• Co.’s policy communication to staff, Completing returns required by
FSA, maintaining co. compliance manual etc.
 Contract Law

• Contract – An agreement, enforceable by law, between two or more persons to

do, or abstain from doing, some act or acts, their intention belong to create legal
relations and not merely to exchange mutual promises.
• So insurance contract is an agreement, enforceable by law, between insured and
insurer.
• Essentials of a valid contract – Contract will invalid or set aside (void ab initio -
from the beginning) if any essentials of contract is missing.
• An agreement must satisfy the 1. Offer and acceptance 2. Considerations.
• Criteria.
• Other important elements to a valid contract:
• Intention to create legal relations Capacity to contract
• Consensus ad idem (Genuine meeting of minds) Legality of the purpose
• Possibility of the performance Certainty of the terms
 Terms of business agreements (TOBA)

• TOBAs reflects the particular methods of doing business.

• General requirements
• All TOBA should:
• Be clear and succinct;
• Reflect the business relationship;
• Define and allocate responsibilities and rights; and
• Ensure compliance with regulatory or statutory rules.
• Status – Obligation on the broker to advise the insurer of their
regulatory status & of any change to that status. Business classes to
which TOBA applies.
• Commission – Commission due date, Scale of commission rate,
minimum notice period for changes.
 Insurable Interest
Def. – The legal right to insure arising out of a financial
relationship recognised at law, between the insured and the
subject matter of insurance.
It is a necessary element to create a valid insurance contract.
Features of Insurable interest:
• Subject matter;
• Legal relationship; and
• Financial value.
 Creation of Insurable Interest
I.I in subject matter arises:
1. At common law;
2. Under contract; and
3. Under statute
 Utmost Good Faith
Principle of Utmost Good Faith
Def. – A positive duty voluntarily to disclose,
accurately and fully, all facts material to the risk
being proposed, whether requested or not.
• Proposer has duty to disclose all material facts
about the risk.
 Duty of disclosure
Material fact (Def.) – Every circumstance is
material which would influence the judgement
of a prudent insurer in fixing the premium or
determining whether he will take the risk.
Insured’s duty of disclosure – Insured makes
full & complete disclosure of all material facts
relating to the contract for claim payment due
to occurrence of a loss.
 Material Fact
Features of material fact - Fact is material by looking at
it from a prudent insurer’s point of view.
Material facts in non-life proposals
Material facts relate to either physical or moral hazard.
Physical hazards
Fire insurance: Construction of building, nature of use,
heating & electrical system.
Motor insurance : age & type of car, age of driver,
whether full licence held, previous accident.
Theft insurance: nature of stock, its value and nature of
security.
 Material Fact
Moral hazards – relate to insurance history of
the insured, or their personal history or
attitude.
Insurance history: Previous refusal to insure by
other insurer, previous claim history of fraud or
exaggeration.
Personal history: Criminal conviction, lack of
good management of business premises,
excessive or wilful carelessness
 Meaning of Proximate cause
Def. – The active, efficient cause that sets in
motion a train of events which brings about a
result, without the intervention of any force
started and working actively from a new and
independent source.
 Meaning of Proximate cause

Lighted match in garage

Rags on fire

Gas cylinder explodes

Wall garage blow out

Burning material blow into office

 Application to simple claims
Two things when decided if a loss is covered:
• Which perils are clearly stated as covered by
the policy,
• Which perils are clearly not covered by the
policy (Excepted policy).
 Indemnity
Def. - Financial compensation sufficient to
place the insured in the same financial position
after a loss as they enjoyed immediately before
the loss occurred.
 Indemnity
Benefit policies – Policies that provide fixed
benefits, mainly accident & sickness insurance &
are called short term policies because insurance
has the option of inviting renewal at the end of
each period of insurance. Some general policies are
not policies of indemnity.

Examples : Personal accident, Sickness, Critical

illness, Payment protection indemnity, Hospital
cash plan, Permanent health, & elements of travel
of insurance.
 Indemnity

Settlement Option available to insurers -

The insurer has the legal right of financial
compensation.
• Cash Payment
Most economical way
• Repair way to provide
Indemnity
• Replacement indemnity by
• Reinstatement insurers
 Contribution
Double (or Dual) Insurance - 2 types of
insurance provide cover in the event of the
loss e.g.
• All risk policy & travel policy both cover travel
& possibly the same property whilst abroad;
• A specific warehouse stock policy & a floating
policy covering stock over several
warehouses, both covering the same stock
 Contribution
Contribution condition
Def. – The right of an insurer to call upon others similarly, but
not necessarily equally, liable to the same insured to share
the cost of an indemnity payment.
Contribution shares the loss among all insurers who cover the
loss & it support the principal of indemnity .
 Contribution
Requirements for contribution:
1. Common insurable interest – Owner, User, Bailee ;
2. Common perils – Common perils for both contract;
3. Common subject matter – Property.
 subrogation
Def. – ‘ The right of 1 person, having indemnified another
under a legal obligation to do so, to stand in the place of that
other and avail himself of all the rights and remedies of that
other, whether already enforced or not’.
 WHAT IS RISK?

Possibility of Occurrence of Loss

• Uncertainty, Probability, Fortuitous Nature, Unexpected;
• Concerning some event;
• Always associated with loss;
• A situation involving exposure of danger or harm or loss;
• The possibility that something bad or unpleasant (such as
an injury or a loss) will happen.
No single definition of risk exist - Economists, behavioral
scientists, risk theorists, statisticians, and actuaries each have
their own concept of risk.
Risk is related to cause and effect relationship.
 Types of Risk
• Pure Risk - Situation in which there are only the
possibilities of loss or no loss.

• Speculative Risk - Situation in which there are possibilities

of loss or no loss or gain.

• Particular or Diversifiable Risk - A risk that affects only

individuals or small groups or specific objects.

• Fundamental or Non-diversifiable Risk - A risk that affects

the entire economy or large numbers of persons or groups
within the economy. It can be both natural or man-made.
 Types of Risk
Objective Risk (also called degree of risk) - Relative variation of actual loss from
expected loss .
• 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.
Subjective Risk - Uncertainty based on a person’s mental condition or state of mind .
• For example, high speed driving, using mobile phone while driving etc. The driver
may be uncertain whether he will arrive home safely without being convicted by
the traffic police.
• A factory owner always have uncertainty in mind for successful business proceeds
whereas another factory owner has a lesser uncertainty.
• This mental uncertainty is called subjective risk.
 Types of Risk
Financial Risk - A risk that business firms face because of
adverse changes in commodity prices, interest rates,
foreign exchange rates, and the value of money.
A risk has direct financial consequences.
Non Financial Risk - A risk has no direct financial
consequences, such as uncertainty related to career
selection.
Enterprise Risk
– Enterprise risk is a term that encompasses all major risks faced by a business firm. Such risks
include pure risk, speculative risk, strategic risk, operational risk, and financial risk. Strategic
risk refers to uncertainty regarding the firm’s financial goals and objectives; for example, if a
firm enters a new line of business, the line may be unprofitable.
– Operational risk results from the firm’s business operations. For example, a bank that offers
online banking services may incur losses if “hackers” break into the bank’s computer.
 Types of Risk
Personal Risks
– Personal risks are risks that directly affect an individual or family. They involve
the possibility of the loss or reduction of earned income, extra expenses, and
the depletion of financial assets. Major personal risks that can cause great
economic insecurity include the following:
– Premature death
– Insufficient income during retirement
– Poor health
– Unemployment
 Types of Risk
Property Risks
– Persons owning property are exposed to property risks —the risk of having
property damaged or lost from numerous causes. Homes and other real estate
and personal property can be damaged or destroyed because of fire, lightning,
flood, windstorm, and numerous other causes.
– There are two major types of loss associated with the destruction or theft of
property:
1. Direct Loss | A direct loss is defined as a financial loss that results from the
physical damage, destruction, or theft of the property.
2. Indirect or Consequential Loss | An indirect loss is a financial loss that results
indirectly from the occurrence of a direct physical damage or theft loss.
 Types of Risk
Liability Risks
• Liability risks are another important type of pure risk
that most persons face. Under our legal system, you
can be held legally liable if you do something that
results 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. Usually,
liability risks are directly related to Law of Tort where
one person owes the certain level of care to another
person. A wrongful act or an infringement of a right
(other than under contract) leading to civil legal
liability, such as negligence, nuisance, trespass,
defamation etc.
 Risk Management

Risk Management - The identification, measurement and economic

control of the risks that threaten the assets and earnings of a business
or other enterprise OR The identification, measurement, control and
financing of risks which threaten the assets, the earnings of the
personnel of an organization, or the services it provides.
Stages of Risk Management:
1. Risk identification
2. Risk measurement
3. Risk treatment:
✓ Risk avoidance
✓ Risk reduction
✓ Risk transfer
✓ Risk acceptance
4. Risk financing
5. Monitoring of risk management programme
 Introduction
Risk Management is concentrated in following 3-areas:
• Insurable risks face by the businesses
• The treasury risk of the businesses, and
• Major risks facing the public in such areas as nuclear
energy, pharmaceutical and medical research.

A structured system of risk identification is essential because:

• Risks can be managed only when identified
Risk identification must be:
1. Rigorous
2. Flexible
3. Formal
 Risk Identification
Selection of a Method of Risk Identification
may include:
1. Source of the risk
2. Loss producing event
3. Assets, persons or services effected
4. Consequences of the loss producing event
 Risk Identification
Cause Effect
Natural Phenomena Liability

Materials / supply failure Loss Property damage

Producing
Occurrence
Human Activity (Internal) Loss of earnings

Human Activity (External) Other pecuniary

loss
 Risk Identification
Risk identification methods
Risk Charting Check lists
Organization charts Flow charts
Fault tree analysis and HAZOPs Accounting data
Other documentary sources Site visits

Risk Charting
Threats Resources Consequences Modifying
factors
Financial, Physical Consequences of the Make a
or personal on realization of specific particular risk
which threats types of threat more or less
may act likely to occur
 Risk Identification
Check lists
General purpose

Using resources

Check lists

Using threats

Using loss-
producing
events
 Risk Identification

Organization charts – It considers the

responsibilities of each function and the risks
associated by these functions
 Risk Identification

Flow charts – Depicts risks on each stage of the

operations of organization
Services

Flow charts
Distribution
develops for

Production
 Risk Identification

Fault tree analysis and HAZOPs - Identify successive causes & the
consequences of all kinds of abnormal conditions at each stage of a
process.
Accounting data – Helps in risk identification for revenue & profits.
The accounting data of whole organization should be considered for
risk identification.
• Departmental accounting data analysis may mislead

Other documentary sources – Annual reports, press releases, plans &

products literature etc.
These documents can provide early warnings of future risks.
Site visits – Risk manager personally visits the site and better than
desk based research.
 Risk Measurement
• Important Investment Risk Measurement
Techniques:
1. Standard Deviation;
2. Sharpe Ratio;
3. Beta;
4. Value at Risk (VaR);
5. R-squared.
Risks related to Insurance:
1. Risk surveys;
2. Maximum Probable Loss (MPL).
 Risk treatment

1.Risk avoidance
2.Risk reduction
3.Risk transfer
4.Risk acceptance
Risk treatment
Risk avoidance - Not performing any activity that may carry risk. It
attempts to minimize vulnerabilities which can pose a threat. Risk
avoidance and mitigation can be achieved through policy and procedure,
training and education and technology implementations.
• The production of a proposed product is canceled
because the danger inherent in the manufacturing
process creates a risk that outweighs potential profits
e.g. Gases emits from a Lead Recycling Plant.
• Risk reduction - Reduce the frequency or severity of
losses, also known as loss control. May include
engineering, fire protection, safety inspections, or
claims management.
Risk treatment

• Risk transfer:
1. Insurance (Pay premium & insured receive coverage for
defined losses – Vehicle &property insurance); and
2. Contract – Landlord and tenants, Rent a car
Risk Acceptance - Commonly found in the business or
investment fields. Accepting the identified risk and not taking
any other action in order to reduce the risk because we can
accept its impact, the possible consequences
E.g. Self insurance against catastrophe like earthquake etc.
 Risk financing
Risk financing involves the identification of risks, determining how
to finance the risk, and monitoring the effectiveness of
the financing technique that is chosen. Mechanisms include savings and
reserves, access to credit and market-mediated risk transfer products such
as insurance and catastrophe bonds.
Identifying financial risk:
1. Liquidity risk - Entity will not have sufficient funds available to pay
creditors and other debts.
2. Funding risk
3. Interest rate risk
4. Foreign exchange risk
5. Commodity price risk
6. Business or operating risk.
 Monitoring of risk management
programme
• Risk monitoring is the process which tracks
and evaluates the levels of risk in an
organization.
• The findings which are produced by risk
monitoring processes can be used to help to
create new strategies and update older
strategies which may have proved to be
ineffective.