JIMMA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF MANAGEMENT

RISK MANAGEMENT AND INSURANCE

MODULE (MGMT 332)

Prepared by:

1. Wendwesen Siyum ( BA, PGDIMM,MBA)

2. Shimelis Zewde ( phD)

3. Zerihun A yenew (BA,MBA)

4. Mulualem Waju (BA,MBA)

EDITORS :

Taye Amogne (Bsc,MBA)

Reta Megerssa (Bsc, MBA),

APRIL 2010
JIMMA, ETHIOPIA
MODULE OUTLINE

UNIT ONE : RISK : MEANING,CORE CONCEPTS AND BASIC CATEGORIES

UNIT TWO : RISK MANAGEMENT

UNIT THREE: INSURANCE CONTRACTS

UNIT FOUR : LEGAL PRINCIPLES OF INSURANCE CONTRACTS

UNIT FIVE: PROPERTY INSURANCE CONTRACTS

UNIT SIX : LIABILITY INSURANCE CONTRACTS

UNIT SEVEN : LIFE INSURANCE CONTRACTS

UNIT EIGHT : INSURANCE BUSINESS IN ETHIOPIA

Course introduction: Risk Management and Insurance

Welcome to the course : “Risk management and insurance,” Dear students, this module introduces you

to the basic concepts, principles, types and practices of risk management and insurance contracts as

they are applied to many organizations. The material was prepared with a strong intent and devotion to

make it attractive-both academically and practically relevant and it was designed to instigate critical

thinking and learning. The course pay special attention to the application of varies theories and

concepts of “Risk management and insurance,” in organizational settings so that a reader would

appreciate how they would be applied in practical world and situations.

Therefore, the module under consideration gives a wider discussion of the definitions and types of

risk that organizations suffer, ways of managing these risks ,insurance contracts concepts and their basic

categories.

Each unit in the module is divided into different sections. The central concept of the sections depends

upon the issues discussed under each respective unit.

Each section comprises text questions that help you discuss while you are reading the module. This

endeavor will let you grasp the central concepts and themes of the course and paves the way to

internalize and understand the subject matter.

To understand this module ,you are advised to spend a minimum of one hundred twenty hours. Your

study is facilitated by self test exercises. Try to make the best out of these exercises. Whenever you feel

you are not in a position to answer these questions, read the required section again and again. Besides ,

you are expected to capture the main concepts the lesson under consideration in order to grasp the

whole material in an easy and simple fashion.

Objectives of the module:

Upon completion of this module, you will be able to :

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Define the term risk in diversified ways

Explain the basic types of risks

Understand risk and risk related ideas

Define the term risk management and its processes

Understand what is meant by insurance contract

Explain the different features of insurance contracts

Elaborate the basic concepts and kinds of legal principles of insurance contracts

Explain the meaning and kinds of property insurance contracts

Define the meaning and kinds of liability insurance contracts

Understand the meaning features and kinds of life insurance contracts

Elaborate insurance business in Ethiopia

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 Unit one

Risk: Meaning, Core Concepts and Basic Categories

Learning objectives

After completing this unit, you will be able to :

Understand the term risk

Differentiate the term risk from peril and hazard and uncertainties

Elaborate the basic categories of risk

SECTION – I

Definition of risk and risk related topics

Section overview

There is no single definition of risk. Economists, behavioral scientists, risk theorists, statisticians,
and actuaries each have their own concept of risk. However, risk traditionally has been defined
in terms of uncertainty. Based on this concept, risk is defined here as uncertainty concerning
the occurrence of a loss. Where hazard is a condition that creates or increases the chance of
loss.

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Objectives of this section
After completing this section, you will be able to:
 Define Risk
 Differentiate risk and risk related topics (such as Hazard, peril and uncertainties)
 Explain Risk by your own terms.

Out line of this section

1. Definition of risk
2. Risk and Hazard
3. Risk and peril
4. Risk and uncertainties

1.1 Definition of risk

Dear student! Would you define the term risk from your own experience?

Well!! There is no single definition of risk. Each discipline has given its own definition to the
term risk. That is economists, behavioral scientists, risk theorists, statisticians and actuaries
each have their own concept of risk. Here are some of the definitions given to the term risk.
 Risk is defined as uncertainty concerning the occurrence of a loss.
 Risk is a combination of hazards.
 Risk is the possibility of an unfortunate occurrence.
 Risk is unpredictability-the tendency that actual results may differ from predicted
results.
 Risk is the possibility of loss.
Hence the value of having a single definition is questionable because it is likely to be limited in
its ability to capture the comprehensive flavor of risk. It is more valuable to dissect the idea of
risk and consider its component parts.
1.2. Risk and Hazard

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Dear student! What does hazard mean? Would you discuss from your own experience?

Well! A hazard is a condition that creates or increases the chance of loss. Here hazards are not
the cause of loss by them selves; rather they can increase or decrease the effect of loss. There
are four major types of hazards. These are:
 Physical hazard
 Moral hazard
 Morale hazard and
 Legal hazard. Let us see one by one

A. Physical Hazard: is a physical condition that increases the chance of loss. Examples of
physical hazards include icy roads that increase the chance of an auto accident,
defective wiring in a building that increases the chance of fire and a defective lock on a
door that increases the chance of theft
B. Moral Hazard: is dishonesty or character defects in an individual that increase the
frequency or severity of loss. Examples of moral hazard include taking 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, murdering the insured to
collect the life insurance proceeds etc.
Moral hazard is present in all forms of insurance, and it is difficult to control. Dishonest
individuals often rationalize their actions on the grounds that “the insurer has plenty of
money”. This view is incorrect because the insurer can pay claims only by collecting
premium from other insured. Because of moral hazard, premiums are higher for everyone.
Dear student! would you describe some of the examples of physical hazards and moral
hazards that you are familiar with at your working environment

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C. Morale hazard is carelessness or indifference to a loss because of the existence of
insurance. Example of morale hazard include leaving car keys in an unlocked car, which
increases the chance of theft; leaving a door unlocked that allows a burglar to enter,
hence careless acts like these increase the chance of loss.
Dear student! You are expected to differentiate between moral hazards and morale
hazards. That is, moral hazard refers to dishonesty by an insured that increases the
frequency or severity of loss, where as morale hazard is carelessness or indifference to a
loss because of the existence of insurance.
D. 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 a wards in liability law suits,
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.

1.3. Risk and peril

? Dear Student! Would you Define Peril?

Well! Peril is defined as the cause of loss. If your house burns because of a fire, the peril, or
cause of loss, is the fire. If your car is damaged in collision with another car, collision is the
peril, or cause of loss. Common perils that cause property damage include, fire lightning,
windstorm, earth quakes, theft, and burglary.
Dear student! Would you describe some other perils which you are familiar with?

1.4 Risk and uncertainties

? Dear student! What does uncertainty mean?

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Well! the concept of uncertainty implies doubt about the future based on a lack of
knowledge, or imperfection in knowledge Risk exists regardless of whether this doubt has
been recognized by those who may be most directly involved.
As we have already defined, uncertainty is one of the components of the concept of risk. As
per the broader idea of risk and using our understanding of uncertainty, we could say that
the basis of risk is lack of knowledge, regardless of whether the state of lack of knowledge
is recognized. If we always knew what was going to happen there would be no risk. We
would know for certain if our house was to burn down this year. If we were to have an
accident, if the burglars were to select our house, if our car was to be stolen, and so on. We
do not have this knowledge and hence we live in an uncertain or risky environment. We can
therefore say that risk exists out side the individual, it may be recognized as existing but this
is not a pre-requisite. In this sense, it is objective and not depends on any one individual.

Review Questions
1. Define the term risk

2. Explain the followings

A. Risk and Hazard

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 B. Risk and Peril

C. Risk and uncertainties

Section-2
Basic categories of Risk
Section overview
Risk can be categorized in to several distinct categories. Hence this section deals with pure and
speculative risk, objective and subjective, financial and non-financial fundamental and specific
risks.

Objectives of this unit

After completing this section, you will be able to:
 Classify pure and speculative risks
 Make distinction between objective and subjective risk
 Differentiate between fundamental and specific risks

Section outline
2.1. Pure and speculative risks
2.2. Objective and subjective risks
2.3. Financial and non-financial
2.4. Fundamental and specific risks

2.1. Pure and speculative risk

2.1.1. Pure Risk
Dear student! Would you define pure risk?

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Well pure risk is defined as a situation in which there are only the possibilities of loss or no loss.
The only possible out comes are adverse (loss) and neutral (no loss). Examples of pure risks
include premature death, job-related accidents, catastrophic medical expenses, and damage to
property from fire, lightning, and flood or earth quake
Categories of pure risks that are associated with great financial and economic insecurity include
personal risks, property risks, and liability risks
I. Personal Risks- are risks that directly affect an individual; they involve the possibility
of the complete loss or reduction of earned income, extra expenses, and the
depletion of financial assets. In addition to this, they refer to the possibility of loss to
a person such as death, disability, loss of earning power etc. There are four major
personal risks.
A. Risk of Premature Death: - This refers to the death of a household head with unfulfilled
financial obligations. These can include dependents to support, a mortgage to be paid
off, or children to educate. If the surviving family members lack additional sources of
income or have insufficient financial assets to replace the lost income, financial hardship
can result.

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Premature death can cause financial problems only if the deceased has dependents to
support or dies with unsatisfied financial obligations. Thus, the death of a child age ten is
not “Premature” in the economic sense
B. Risk of old age: The major risk associated with old age is insufficient income during
retirement. When older workers retire they lose their normal work earnings. Unless
they have accumulated sufficient financial assets on which to draw or have access to
other sources of retirement income, such as social security or a private pension, they
will be confronted with a serious problem of economic insecurity.
C. Risk of poor health: Poor health is the other personal risk. The risk of poor health
includes both catastrophic medical bills and the loss of earned income. Unless persons
have adequate health insurance or other sources of income to meet these expenditures,
they will be financially insecure.
D. Risk of unemployment: unemployment can result from a business cycle-downsizing
from technological and structural changes in the economy, from seasonal factors, and
from fluctuations in the labor market.
II. Property Risk: refers to losses associated with ownership of property. Property risk
stems from diverse perils accompanied by different hazards: physical moral or
morale. Real estate and personal property can be damaged or destroyed because of
fire, lightening, windstorms, and numerous other causes. Property losses can be
classified as follows
A. Classification Based on property class
Property may be divided in two broad classes
1. Real estate or land and its attachments vacant land, an office building, a
manufacturing plant, warehouse, or some other structure illustrates real estate.
2. Personal property or property that is movable and not attached to land personal
property includes such items as machinery, pottery, and dies furniture and fixtures,
raw materials goods in process, finished goods, merchandise for sale, supplies and
money and securities.
B. Classification Based on the cause of the loss. This encompasses the followings

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 1. Physical Cause: physical perils include such natural forces as fire, windstorms and
explosions that damage or destroy property.
2. Social Cause: Social perils are
a. Deviations from expected individual conduct such as theft, embezzlement, a
negligence or
b. Aberrations in group behavior such as strikes or riots.
3. Economic: economic perils may be due to external or internal forces example, a
debtor may be unable to pay off an account receivable because of an economic
recession or a contractor may not complete a project on schedule because of a
management error.
C. Direct and Indirect loss
1. Direct loss: is a financial loss that results from the physical damage, destruction, or theft
of the property. For example if you own a restaurant that is damaged by a fire, the
physical damage to the restaurant is known as a direct loss.
2. Indirect or consequential loss:- is a financial loss that results indirectly from the
occurrence of a direct physical damage or theft loss
Thus, in addition to the physical damage loss, the restaurant would lose profits for several
months while the restaurant is being rebuilt. The loss of profits would be a consequential
loss. Other examples of a consequential loss are the loss of rents, the loss of the use of the
building, the loss of a local market, and continuing expenses.
Extra expenses are another type of indirect or consequential loss. For example, suppose you
own a news paper, bank or dairy. If a loss occurs, you must continue to operate regardless
of cost, other wise, you will lose customers to your competitors. It may be necessary to set
up a temporary operation at some alternative location, and substantial extra expenses
would then be incurred.
III. Liability Risks: are other types of pure risk that most persons face. Hence liability
risk is the possibility of loss arising from intentional or unintentional damage made
to other persons or to their property. One would be regally obliged to pay for the

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 damages he inflicted up on other persons or their property. A court of law may order
you to pay substantial damages to the person you have injured.
Speculative Risk
Dear student! Would you define speculative risk by your own terms?

Well 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 the
stock increases but would lose if the price declines. Gambling is a good example of a
speculative risk. In a gambling situation, risk is deliberately created in the hope of gain.
The term pure risk, in contrast, is used to designate those situations that involve only the
chance of loss or no loss. One of the best examples of pure risk is the possibility of loss
surrounding the ownership of property. The person who buys an automobile, for example,
immediately faces the possibility that something may happen to damage or destroy the
automobile. The possible outcomes are loss or no loss.
Dear student! would you further describe the distinction between pure and speculative
risks?

Well! The distinction between pure and speculative risks is an important one, because normally
only pure risks are insurable. Insurance is not concerned with the protection of individual’s
against those losses arising out of speculative risks. Speculative is voluntarily accepted because
of its two-dimensional nature, which includes the possibility of gain. No all pure risks are
insurable.
2.2. Objective and subjective risks
Deal student! Discuss objective and subjective risks

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Well! Objective risk is defined as the relative Variation of the actual loss from expected loss. For
example, assume that a fire insurer has 10,000 houses insured over a long period and, on
average 1 percent, 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, while 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 percent. This relative variation of actual loss from expected
loss is known as objective risk.

According to George E. Rejda (2008, P.3) objective risk declines as the number of exposures
increases. More specifically objective risk varies inversely with the square root of the number of
cases under observation. In our previous example, 10,000 houses were insured, and objective
risk was 10/100, or 10 percent. Now assume that 1 million houses are insured. The expected
number of houses that will burn is now 10 000, but the variation of actual loss from expected
loss is only 100. Objective risk now is 100/10000, or 1 percent. Thus, as the square root of the
number of houses increased from 100 in the first example to 1000 in the second example (ten
times), objective risk, declined to one-tenth of its former level.

Objective risk can be statistically measured by some measure of dispersion, such as the
standard deviation or the coefficient of variation. Since objective risk can be measured, it is an
extremely useful concept for an insurer or a corporate risk manager. 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 numbers. The law of large numbers states that as the number of
exposure units increases, the more closely will the actual loss experience approach the
probable loss experience. For example, as the number of homes under observation increases,
the greater is the degree of accuracy in predicting the proportion of homes that will burn.
2.2.2. Subjective Risk
Deal student! What does a subjective risk mean?

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Well! George E. Rejda (2008, P.4) defined subjective risk as, uncertainty based on a person’s
mental condition 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.
The impact of subjective risk varies depending on the individual. Two persons in the same
situation can have a different perception of risk, and their behavior may be altered accordingly.
If an individual experiences great mental uncertainty concerning the occurrence of a loss, that
person’s behavior may be affected. High subjective risk often results in conservative and
prudent behavior, while low subjective risk may result in less conservative behavior. For
example, assume that a motorist previously arrested for drunk driving is aware that he has
consumed too much alcohol.

The driver may then compensate for the mental uncertainty by getting some taking a cab.
Another driver may then compensate for the mental uncertainty by getting some one else to
drive the car home or by taking a cab. Another driver in the same situation may perceive the
risk of being arrested as slight. This second driver may drive in a more careless and reckless
manner; a low subjective risk results in less conservative driving behavior.

2.3. Financial and Non-financial Risk

Deal student! could you define financial risk from your own experience?

Well! Financial risk refers to the uncertainty of loss because of adverse changes in commodity
prices, interest rates, foreign exchange rates, and the value of money. For example, a food
company that agrees to deliver cereal at fixed price to a supermarket in six months may lose
money if grain prices rise. A bank with large portfolio of Treasury bonds may incur losses if
interest rates rise.A financial risk is one where the out come can be measured in monetary
terms. This is easy to see in the case of material damage to property, theft of property or lost

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business profit following a fire. In cases of personal injury, it can also be possible to measure
financial loss in terms of a court award of damages, or as a result of negotiation between
lawyers and insurers. In any of these cases, the outcome of the risky situation can be measured
financially.

There are other situations where this kind of measurement is not possible. Take the case of the
choice of a new car, or the selection of an item from a restaurant menu. These could be taken
as risky situations, not because the outcome will cause financial loss, but because the outcome
could be uncomfortable or disliked in some other way. We could even go as far as to say that
the great social decisions of life are examples of non-financial risks: the selection of a career,
the choice of a marriage partner, having children. There may or may not be financial
implications, but in the main the outcome is not measurable financially but by other, more
human, criteria.

In the world of business we are primarily concerned with risks which have a financially
measurable outcome.

2.4. Fundamental and particular risk

Dear student! Would you discuss fundamental and particular risk?

Well! A fundamental risk is a risk that affects the entire economy or large numbers of persons
or groups with in the economy. Examples include rapid inflation, cyclical unemployment, and
war because large numbers of individuals are affected
The risk of a natural disaster is another important fundamental risk. The effect of fundamental
risks is felt by large numbers of people. This classification would include earthquakes, floods,
famine, volcanoes and other natural ‘disasters’. However, it would not be accurate to limit
fundamental risk to naturally occurring perils. Social change, political intervention and war are
all capable of being interpreted as fundamental risk. In contrast to this form of risk, which is

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impersonal in origin and wide spread in effect, we have particular risks. That is, a particular risk
is a risk that affects only individuals and not the entire community. Examples include car thefts,
bank robberies, and dwelling fires. Only individuals experiencing such losses are affected, not
the entire economy or large groups of people.
Dear student! Particular risks are insurable while fundamental risks are not, but it is difficult to
generalize as views in the insurance market place change from time to time. We could say that
fundamental risks are normally so uncontrollable, wide spread and indiscriminate that they
should be the responsibility of society as a whole. The geographical factor is often important,
particularly for natural hazards such as flood and earthquake. In many parts of the world these
risks would be regarded as fundamental and not insurable, but in the United Kingdom they are
insurable

2.5. Static and Dynamic risks

Dear student! Would you discuss static us dynamic risks?

Well! Dynamic risk originates from changes in the overall economy such as price level changes,
changes in consumer changes, income distribution, technological changes political changes and
the like. They are less predictable and hence beyond the control of risk managers. Where as,
static risks, on the other hand, refer to those losses that can take place even though there were
no changes in the overall economy. They are losses arising from causes other than changes in
the economy. Unlike dynamic risks, they are predictable and could be controlled to some
extent by taking loss prevention measures. Many of the perils fall under this category.
2.6. Burden of Risk on Society
Dear student! What do you think that the burden of risk on society?

Well! According to George E. Rejda (2008, p.11) the presence of risk results in certain
undesirable social and economical effects. Risks entail three major burdens on society:
a. The size of an emergency fund must be increased.

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 b. Society is deprived of certain goods and services
c. Worry and fear are present
A. Larger emergency Fund
It is prudent to set a side funds for an emergency. However, in the absence of insurance,
individuals and business firms would have to increase the size of their emergency fund to pay
for unexpected losses. For example, assume you have purchased a birr 300,000 home, and
want to accumulate a fund for repairs if the home is damaged by fire, windstorm, or some
other is damaged by fire, windstorm or some other peril. Without insurance, you would have to
save at least birr 50,000 annually to build up an adequate fund with in a relatively short period
of time. Even then, an early loss could occur, and your emergency fund may be insufficient to
pay the loss. If you are a middle income wage earner, you would find such saving difficult. In
any event, the higher the amount that must be saved, the more current consumption spending
must be reduced, which results in a lower standard of living .

B. Loss of certain Goods and services

A second burden of risk is that society is deprived of certain goods and services. For example,
because of the risk of a liability lawsuit, many corporations have discontinued manufacturing
certain products. Numerous examples can be given some 250 companies in the world once
manufactured childhood vaccines, today, only a small number of firms manufacture vaccines,
due in part to the threat of liability suits. Other firms have discontinued the manufacture of
certain products, including asbestos products, football helmets, silicone-gel breast implants,
and certain birth control devices because of fear of legal liability.
C. Worry and Fear
A final burden of risk is that worry and fear are present. Numerous examples can illustrate the
mental unrest and fear caused by risk. Parents may be fearful if a teenage son or daughter
departs on a skiing trip during a blinding snow storm because the risk of being killed on an icy
road is present. Some passengers in a commercial jet may become extremely nervous and
fearful if the jet encounters severe turbulence during the flight.

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 References

Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company

,USA Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc
Graw Hill company ,USA
nd
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 ed, 2002
Jhon Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw
Hill company ,USA
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA
Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA
Rejda, George, Principles of Risk Management and Insurance,10th
ed.,2004,Pearson International ed.,USA
Skipper, Harold and W. Jee ,Risk Management and Insurance: Perspectives in a
Global Economy,2007, Black well Publishing,Australia
Trieschmann, Hoyt and sommer,Risk Management,12 th ed. 2005, South Western ,USA

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 Unit Two
Risk Management

Learning objectives
After completing this unit, you will be able to :
Understand the meaning of risk management
Explain objectives of risk management
High light the risk management process
Section 1-
Meaning and Objectives of Risk management

Section overview
Dear students! Risk management is defined in different ways by practitioners and risk theorists.
But one can note the common themes (ideas) raised by different definitions. These common
themes about the meaning of risk management include:
 It deals with mostly pure risks-both insurable and uninsurable ones
 It is a process consisting of the identification, measurement, and handling of risks
 It is broader than insurance management

Objectives
After completing this section, you will be able to:
 Define risk management
 Understand the scope of risk management
 Identify pre-loss and post-loss objectives of risk management
Section outline
3.1. 1 Meaning of risk management
3.1.2 Objectives of risk management
1. Pre-loss objectives
2. Post-loss objectives

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3.1.1 Meaning of Risk Management

Dear student! what do you think is risk management? Define risk management in your own
terms.

Risk management can be defined in many ways. Let us see two definitions of risk management.
Definition 1: Risk management is a process that identifies loss exposures faced by an
organization and selects the most appropriate technique for treating such exposures.
A loss exposure is any situation or circumstance in which a loss is possible, regardless of
whether a loss actually occurs.
Examples of loss exposures include:
 a residential home that can be caught by fire
 occupational disease and injury that can be faced by employees of an
organization
 professional malpractices that may result in law suits against physicians,
lawyers, teachers, etc
 the possible theft of a company because of lack of security

Definition 2 . Risk management is a scientific approach to dealing with pure risks by anticipating
possible accidental losses and implementing procedures that minimize the occurrence of loss or
the financial impact of losses that do occur.

The following points about risk management can be noted from the above definition:
 Risk management is a scientific approach to dealing with pure risks. Although risk
management seeks to proceed in a scientific manner, it is not, however, a science in the
same sense as are the physical sciences (like physics, chemistry) which derive their laws and
principles from controlled laboratory experiments. Risk management does not follow the
same approach. Instead it derives its rules (laws) from the general knowledge of experience,
through deduction, and from concepts drawn from other disciplines, particularly decision
theory. In this sense, we say risk management follows a scientific approach.

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 Risk management deals with pure risks. Traditionally the scope of risk management has been
limited only to pure risks-personal, property, and liability risks. In fact risk management is
distinguished from traditionalmanagement because of its scope. While general management is
responsible for dealing with all risks, both pure and speculative, facing the organization, risk
management is limited to the management of pure risks. General managers in large organizations
delegate the pure risk segment of the total risk to risk managers. But in recent years there is a
considerable discussion among scholars and practitioners to broaden the scope of of risk
management to entererprise risk management-the management of all forms of risk regardless of
their type.
 Risk management is aimed at minimizing the occurrence of losses (loss frequency) and
minimizing their financial impact (loss severity) once they occur.
Risk management is a broader concept and differs from insurance management. In addition to
insurance, risk management uses other techniques to treat loss exposures, which include
avoidance, loss control, retention, and non insurance transfer. Insurance management is only
part of risk management.

3.1.2 Objectives of Risk Management

Dear distance learner! What do you think are the benefits of risk management? List them
down.

Risk management has many objectives which can be broadly divided into two as:
1. Pre-loss objectives and
2. Post-loss objectives
1) Pre-Loss Objectives Of Risk Management
As the term ‘pre-loss’ implies, pre-loss objectives of risk management are achieved before a
loss occurs. These objectives include:

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A.) Economic objective- This refers to dealing with loss exposures faced by a firm in the
most economical manner. To achieve this objective the risk manager should analyze the
cost of different safety programs, insurance premiums and the costs associated with
different techniques for handling risks.
B.) Reducing anxiety- An appropriate risk management program relieves employees and
managers from varied degrees of worry and fear related to the possible occurrence of a
loss. For example, the threat of fire in a large manufacturing plant can cause greater
anxiety than a small loss from theft. By reducing anxiety, risk management enables
organizational members to concentrate on their main responsibilities.
C.) Meeting legal obligations- Risk management enables an organization to meet any legal
obligations imposed by government. For example, government regulations may require
a firm to install safety devices to protect its workers from harm.

2) Post-Loss Objectives of Risk Management

No matter how precautionary measures are taken by a firm, losses are inevitable.
After a loss occurs, risk management can achieve the one or more of the following
objectives.
A.) Survival of the firm- After a loss occurs, the firm can continue operation, at least
partially, with in short period of time.
B.) Uninterrupted operation- For some organizations resuming operation soon after
the occurrence of a loss is extremely important. Those organizations include:
 Government utility suppliers- like telecommunications, water & sewerage, and fire
brigades.

 Highly competitive firms- like banks, bakeries, laundries. These type of

organizations may lose customers to competitors unless they continue their
operation soon after a loss occurs.
C.) Growth of the firm- Beyond mere survival, firms need to grow by developing
new products/services, entering into new markets, acquiring or merging with other

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 companies, etc. Additional risks that may arise with these growth o initiatives and
the appropriate handling of those risks are taken care of by risk managers.
D.) Social responsibility- The objective of social responsibility is to minimize the painful
effects that a loss will have on other persons and society. A severe loss to a firm
can affect its employees, creditors, suppliers, and the community at large.

Section 2-
Risk Management Process
Section overview
The risk management process can be divided into a series of individual steps that must be
accomplished in managing risks. Dear student! Identifying these individual steps will help you
guarantee that important steps in the process will not be skipped. Skipping any of the steps
and/or haphazardly performing them will result in ineffective risk management. You should also
understand that these steps are discussed here separately for the purpose of analysis. But in
actual practice these steps tend to merge with one another.
There are four steps in the risk management process. These are:
1) Identify loss exposures (risks)
2) Evaluating or analyzing risks.
3) Selecting appropriate techniques for treating loss exposures and
4) Implementing and monitoring risk management program

23
Objectives of this section
After completing this section, you will be able to:
 Understand the meaning and process of risk identification
 Differentiate loss severity and loss frequency
 Apply rules of probability to estimate loss frequency and severity
 Identify different techniques of treating loss exposures- risk control and risk financing
techniques
 Understand how to implement and monitor risk management program

Section outline
3.2.1 Identifying Loss Exposures
3.2.2 Evaluating (Analyzing) Risks
3.2.3 Selecting the Appropriate Tools of Risk Management
3.2.4 Implementing and Monitoring the Risk Management Program

3.2.1 Identifying Loss Exposures

Risk identification is the process by which a business systematically and continuously identifies
property, liability and personnel loss exposures as soon as or before they emerge.
There are many risks that confront individuals and organizations. Therefore, the first step in risk
management is to identify all major and minor loss exposures. It is difficult to generalize about
the risks that a given type of organization is likely to face because differences in operations and
business environments result in varying risks. Thus, in order to reduce the possibility of failure
to discover risks facing a firm, there should be a systematic approach to the identification of
risks.

24
 Steps in risk identification

1. Preparation of a checklist of all losses that could occur to any business

2. Discovering which of the potential losses included in the check list are faced by the
organization.
1. Preparing Exposure Checklists
An exposure checklist is simply a listing of common loss exposures that may happen to any firm.
Though the checklist cannot include all possible exposures, it can be used with other risk
identification tools as a final check to reduce the chance of overlooking serious exposures. The
risk manager should identify property, liability and personnel loss exposures to the firm.
A. Property loss-Property check list can facilitate the risk identification process. The risk
manager should prepare a listing of various assets owned by the firm. He can as well identify
the perils that can possibly cause property losses. The exposed value of each property will also
be entered in the check list to have a clear picture as to the severity of a loss in case the
property is damaged or destroyed by a particular peril.

B. Liability loss- Third party liability losses refer to injuries caused to other people or damage
caused to their property. Firms are exposed to liability risk by virtue of their operating activity.
It is the responsibility of the risk manager to identify the possible liability losses that the firm
may be exposed to.

Some of the factors that lead liability losses are as follows:

 Product liability – this risk is associated with the manufacturing and sell of a product.
Quality problems, breach of warranty, misleading advertisements are some of the
factors that lead to liability losses.
 Use of Motor vehicles – Use of various types of motor vehicles (buses, trucks, small
cares, and motor cycles) exposes the firm to third party liability losses. Operation of
motor vehicles could lead to killing of people, injuries and damages caused to the

25
 property of other people due to accidents such as fire, collusion, overturning, crash,
explosion etc.
 Industrial accidents- factory employees are likely to suffer physical injuries at work sites.
In some type of activities they may develop job related diseases. This is particularly true
in chemical industries, and cement factors.
 Industrial waste- This refers to industrial garbage’s thrown in to rivers and lakes there by
polluting the environment. Environmentalists are likely to file a law suit against the
activities of polluting firms, especially concerning the firms wastes disposal practices.
 Professional activities- In the field of public Accounting, Medicine, Construction and
other professional activities, liabilities are likely to emerge because of the deficiencies
inherent in the service rendered due to the negligence, errors, intentional concealment
and the like.
 Ownership of immovable- This refers to buildings, land, machinery. The use of such
immovable by people may bring liability losses for injuries cased by accidents. Example –
old building, faulty elevators, escalators, may cause injury to people while they are using
these facilities.
C. Personnel losses – these are losses to a firm regarding its employees and their families. The
risks include death and bodily injury due to accidents while off duty, industrial accidents,
occupational disease, kidnapping, retirement, and sickness. Employees represent the human
assets (capital) of the firm. Their good health, motivation, moral, dedication and loyalty greatly
increased the value of the firm. As a result the risk associated with personnel losses should also
be carefully examined by the risk manager. The need to avoid personnel risk (enhancing the
safety of employee is justified for a number of reasons: They include
-To boost the moral of employees that leads to higher productivity
- To attract and retain highly qualified employees
- To instill a confidence in the mind of employees that the firm is really caring for the safety of
its employees.

26
Insurance Policy Checklists
Analysis of the insurance policy forms can also help in identifying various types of insurable
pure risks. The risk manager initially collects a sample of insurance policy forms from various
insurers. He, then, proceeds to prepare checklists of various types of pure risks that can be
dealt with insurance. The major problem in using insurance policy checklists for risk
identification is that the checklists contain only insurable risks, ignoring uninsurable pure risks.

2 Application of Checklist
The second step in risk identification is to use the checklist developed in step one to discover
and describe the type of losses faced by a particular business. There are six methods for
determining which of the potential losses in the check list apply to a particular firm and in what
ways:
1. Risk analysis questionnaire
2. The financial statement method
3. The flow chart method
4. Analysis of the environment
5. Planned interaction with other department
6. Statistical record of past loss

Risk Analysis Questionnaires- Also called “fact-finders”, risk analysis questionnaires are
designed to assist the risk manager identify risks facing an organization. The questionnaires
require the manager to answer numerous questions that identify major and minor loss
exposures.

Analysis of documents- Historical and current data about the operations of the organization
can be found from various documents including financial statements leases and other
contracts, inventory records, buy-sell agreements, etc. These documents provide basic source
of information for risk identification. Analysis of firm’s financial statements, in particular, can
aid a lot in the process of risk identification. The asset listing in the balance sheet alerts the risk

27
 manager about assets that might otherwise be overlooked. The income and expense
classification in the income statement indicates the organization’s area of operation.

The flow chart method- Flow charts are graphic or diagrammatic representation of sequential
process . A flow chart depicting (showing ) the operations of a firm can guide a risk manger to
risks associated with those operations. In this method first , a flow chart or series of flow chart
is constructed ,which shows all the operations of the firm , starting with raw materials ,
electricity , and other inputs at suppliers locations and ending with finished products in the
hand of customers .

Analysis of the environment- Analysis of the external environment as well as internal

environment helps in identifying the exposures of a particular firm. The basic component of the
environment includes customers, suppliers, competitors, (government) regulators.
Interaction with other departments- Another way to identify the losses facing a business is
through systematic and continuous interaction with other department in the business. The
interaction can be:
 Onsite inspection of facilities and operation, including relation ship with others. On site
inspection is a must for the manager .By observing first hand the organization facilities and the
operations conducted there on the risk manager can learn much about the exposures faced by
the firm.
 Extended visits with managers and employees of other departments during with the risk
manager attempts to obtain a complete understanding of their activities and potential losses
created by the activities .
 Oral and written reports from other departments on their own initiative or in response to a
regular reporting system , that keeps the risk manager informed of all relevant developments
.The risk managers success in risk identification is heavily dependant up on cooperation he or
she secures form other department .

28
Statistical records of losses- Statistical records allow the risk manager to assess trends in the
organization’s loss experience and to compare the organizations loss experience with the
experience of others. It enables the risk manager to analyze issues such as the cause, time , and
location of accidents , to identify the injured individual and their supervisors, and any hazards
or other special factors affecting the nature of the accident. It is used to develop forecasts of
loss costs. Forecasts of loss costs are very important in designing self –insurance program.

3.2.2 Evaluating (Analyzing) Risks

For each risk that is identified an evaluation should be performed. “Evaluation” involves
estimating the frequency and severity of losses. Loss frequency is the probable number of losses
that may occur during some given time period. Loss severity is the probable size of losses that
may occur.

An estimation of the relative frequency and severity of a loss is essential precondition to the
selection of the best risk handling technique for the risk. Dear learners! The severity and
frequency of losses can be estimated using subjective judgments and statistical techniques.
Now let us see both methods.

Estimating loss severity- Given a wide range of losses, from small to catastrophic ones, that
can occur it is logical to classify and rank exposures according to their impact. Thus, based on
their financial impact on a firm, risks can be classified as critical, important, and unimportant.
Critical risks- include all exposures to losses that can result in the bankruptcy of the firm.
Important risks- are exposures in which the possible losses would not result in bankruptcy but
would require the firm to borrow in order to continue operation.
Unimportant risks- are exposures in which the possible losses could be covered by existing
assets and current income without causing severe financial problem.

29
 To categorize individual exposures into one of the above three categories the amount of
financial loss that may result from the exposures and the capacity of the firm to bear (resist) the
losses should be duly estimated by the risk manager.

Maximum Possible Loss versus Maximum Probable Loss

Another classification for estimating loss severity is maximum possible loss vs. maximum
probable loss.
Maximum possible loss is the worst loss that could occur under the worst possible combination
of circumstances leading to a loss.
Maximum probable loss is the loss that is likely under the most likely combination of
circumstances leading to a loss.

For example: If a factory is completely destroyed by fire, the risk manager estimates that the
replacement cost of machineries, demolition costs, reconstruction costs, loss of business
income until the end of reconstruction, and other costs will total Br. 50 Million. The manager
also estimates that a fire that can cost a loss more than 30 Million Birr is so unlikely that it will
not occur more than once in a century. Thus the maximum possible loss Br.50 Million, while
the maximum probable loss is Br. 30 Million.
Estimating loss frequency- The frequency of occurrence of losses is the function of their
respective probabilities of occurrence. A common subjective approach to classify loss
occurrence probability is as follows:
 Almost nil- meaning that, in the opinion of the risk manager, the event is not going to
happen.
 Slight- meaning that while the event is possible, it has not happened and is unlikely to occur
in the future.
 Moderate- meaning that the event has occasionally happened and will probably happen
again.

30
  Definite- meaning that the event has happened regularly in the past and is expected to occur
regularly in the future.

Although subjective loss severity and frequency estimates discussed above may be of some
help in risk management decisions, when the appropriate data are available more precise
statistical estimates will be useful. A review of some essential concepts from the field of
statistics along with their applications in risk measurement is presented below.

Risk Measurement and Probability Distribution

Probability distributions deal with three different ways of measurement of loss experience.
1. The total dollar loss per year---all loss incurred annually
2. The number of occurrences of risk or accidents per year---frequency of loss or number of risk.
3. The dollar loss per occurrence of accident---Total loss per accident.

Before turning to probability distributions, let us see several interpretations and elementary
rules of probability that should also prove useful to the risk manager.
Rules of Probability
1. Mutually exclusive out comes
Out comes are mutually exclusive if they can not occur together and one of them is sure to
occur. Example –Tossing of a coin—head or teal will turn up .

Under mutually exclusive probability theorem the probability that the actual out come will
be any of a set of two or more mutually exclusive out come is equals to the sum of the
probabilities of separate out comes. The sum of probabilities of all possible mutually
exclusive events must be one because one of these events is certain to occur.

31
 Symbolically:
P (A or B) = P (A) +P (B) =1---If they are two events A and B.
OR
P (A or B or C) = P (A) +P (B) +P(C) =1

In the sense of risk mutually exclusive outcomes do not occur simultaneously, that is say, for
example, if there is a fire accident there must not any case in which it becomes no fire
accident. In addition a warehouse can not both burn and not burn.

2. Compound or joint outcomes or non exclusive events

A compound or joint out come is the occurrence of two or more separate events during the
same period. Example - Fire at factories A and B, a property loss and liability loss arising out
of the same accident.
The occurrence of joint probability depends on two cases
i. Independent case
ii. Dependent case

i. Independent case or event

Two out comes are independent of one another if the occurrence of one out come does not
affect the probability that the other will occur. Example- the probability that a ware house in
Addis Ababa city will burn is not affected by fire loss to warehouse in Jimma town, that means
the two out comes are independent.
If the two out comes are independent, the probability of a compound event is the product of
the probability of independent events. That is

P (A and B) =P (A) .P (B)

32
Example; Assume the probability of fire accident for two factories one in Addis abeba and the
other in Dire Dawa is 1/40 and 1/30 respectively. Now let us represent the factory in Addis
Abeba by letter A and in Dire Dawa by letter D, then
1. Probability of fire accident for both A and D= 1/40.1/30=1/1200
2. Probability of fire accident for A not for D= 1/40.
(1-1/30)=1/40.29/30=29/1200.
3. No fire accident for A but for D=(1-/40).1/30=39/40.1/30=39/1200
4. Fire accident for neither A nor D= (1-1/40).
(1-1/30)=39/40.29/30=1,131/1200.
N.B the sum of the probabilities for the mutually exclusive compound events should be equal to
one , that is 1/1200+29/1200+39/1200+1,131/1200=1

ii. Dependent case or events

Two events are dependent when the occurrence or non occurrence of one event does
affect the probability of occurrence of the other event. The probability that a particular
ware house will burn is increased if adjacent ware house is already burning. Consequently a
loss to one of these ware houses is not independent of a loss to the other.

If two or more out comes are dependent , the probability that both out come will occur is
determined by multiplying probability of A by conditional probability of B, given that A has
occurred. The same result can be obtained by multiplying the probability of B times
conditional probability of A, given that B has occurred.

P (A and B) = P (A).P (B/A)

Example-1: Suppose that a set of ten spare parts is known to contain eight good parts (G) and
two defective parts (D).Given that two parts selected randomly with out replacement, what is
the probability that the two parts selected are both good?

33
Solution:
P (G1and G2) = P (G1).P (G2/G1)
= 8/10.7/9=56/90 or 28/45
Example-2: Consider a bowl containing ten poker chips, six red and four white. A chip is drown
and then a second chip is drown and the first chip is not replaced. Assuming sampling with out
replacement, what is the probability that a sample of two drown in this fashion resulted in two
red chips?

Solution:
P (R1 and R2) = P (R1).P (R2/R1)
= 6/10.5/9=30/90 or 1/3

3. Alternative outcomes
Alternative out come is a probability that A or B occurs. If the two out comes are mutually
exclusive , the probability that at least one of the alternative out come is the sum of the
probabilities that these alternative out come will occur.

P (A or B) = P (A) +P (B)

If the out comes are not mutually exclusive, the probability that at least one of the two out
comes will occur is the sum of the probabilities of the two separate out comes less the
probability that they both occur.

P (A or B) =P (A) +P (B)- P (A and B)

34
Probability Distributions
A probability distribution shows, for each possible outcome, its probability of occurrence.
Because the out comes are mutually exclusive, these probabilities sum to one.

Using probability distributions we can find

 The total loss per year
 The number of occurrence per year
 Loss per occurrence
Total Birr loss per year
Example – hypothetical probability distribution of total property losses in Birr per year to a fleet
of five cars is shown below:
Losses per year ( in birr) Probability
0 0.615
1000 0.270
2000 0.105
5000 0.006
10000 0.003
20000 0.001
Total 1.00
Table 1- Probability of Losses
a) What is the probability that the business will incur some Birr loss?
Given this probability distribution, the probability that the business will suffer no birr loss is
almost 0.615. Because the business must suffer either no loss or some loss , the sum of the
probabilities of no loss or some loss must equal to one . Consequently the Probability of some
loss equals to 1.0-0.615, or 0.385. An alternative way to determine the probability of some loss
is to sum the probabilities for each of the possible total Birr losses, that is 0.270 +0.105
+0.006+0.003 +0.001, or 0.385

35
b) What is the probability that a ‘severe’ loss would occur?
The probability that the total loss will equal or exceed certain specified values is shown in the
table below:
Specified value (in birr) Probability
1,000 0.385
2,000 0.115
5,000 0.010
10,000 0.004
20,000 0.001
Table 2- Probability of losses exceeding a specified value
The potential severity of the total dollar losses can be measured by stating the probability that
the total loss will exceed various values. For example, the risk manager may be interested in the
probability that the losses will equal to or exceed Birr 5000.
These probabilities can be calculated for each of the values in which the risk manager is
interested and for all higher values. For example , the probability that losses will equal or
exceed Birr 5000 is equal to 0.010+ 0.004+ 0.001.

c) Yearly average loss or Expected total Birr loss or average annual Birr loss
This measure reflects both loss frequency and loss severity. It can be obtained by summing the
products formed by multiplying each possible out come by the probability of its occurrence. So,
0(0.615) + 1,000(0.270) +2000(0.105) +5000(0.006)+ 10,000 (0.003)+ 0,000(0.001)=560

This measure indicates the yearly average loss or average annual birr loss the business will
sustain or incur in the long run if it retains the exposure.
Table two has three possible uses:
 To make decisions regarding insurance premium
We can get information on the probability that the losses would equal or exceed the insurance
premium that might be required to purchase complete financial protection .

36
Example: Assume the insurance premium is 900birr, the probability of loss exceeding insurance
premium is 0.385, so it is better to go for insurance because 0.385 is a higher risk.
 To know the probability of severe loss, if retained.
If the risk manager says the sever loss is birr 15,000, then the probability of sever loss is 0.001
which is almost nil .If the sever loss is assumed to be 5,000 or more , hence the probability of
sever loss is 0.01.
 The maximum possible and probable annual total losses
The maximum possible loss is 20,000. If the risk manager thinks that any loss with the
probability 0.003 and less is highly unlikely the maximum probable loss is 10,000.
d) Risk or variations from expected outcomes
One of the most popular yardsticks for measuring risk is standard deviation . Standard deviation
is obtained by subtracting the average value from each possible value of the variable , squaring
the difference , multiplying each difference by the probability that the variable will assume the
values involved , summing the resulting product ,and taking the square root of the sum.

 x.(x  )2
Where:
 = standard deviation
x =The sum of each possible value of the variable
 = The average value or mean

Based on the probability distribution given in the pervious example, the risk or variation from
expected out come is calculated as follows:

37
 X(values)  (average ) x-  (x-  )2 P(x) Px. (x-  )2
1 2 3 4 5 4x5
0 560 -560 313,600 0.615 192,864
1,000 560 440 193,600 0.270 52,272
2,000 560 1440 2,073,600 0.105 218,339
5,000 560 4440 19,713,600 0.006 118,282
10,000 560 9440 89,113,600 0.003 267,567
20,000 560 19440 377,913,600 0.001 377,914
Total of Px. (x-  )2= 1,227,838

 x.(x  )2
= 1,227,838

 = 1108.1
NB.
 When there is much doubt about what will happen because there are many out comes with
some reasonable chance of occurrence , standard deviation will be large
 When there is little doubt about what will happen because only a few possible out
comes is almost certain to occur, standard deviation will be small.
 These observations suggest that the standard deviation of the probability distribution
could serve as a measure of risk associated with the distribution.
Coefficient of variation (CV)
It is a standard deviation expressed as a percentage of mean. It is a relative measure of risk
because it is the average on a particular distribution .The coefficient variation is calculated by
dividing the standard deviation by the expected value.

   / 
Where:
 =coefficient of variation

39
  = standard deviation
 = mean

This measure of risk, unlike probability of loss, have no simple interpretation, they are bounded
by zero and infinity, not zero and one. However, by comparing any of this measure for two or
more distributions, one can determine the relative degrees of risk inherent in those
distributions. If losses from a group of exposure units have a low coefficient of variations, there
is less risk associated with this group of exposures than with another group with a higher
coefficient of variation.

Number of risk occurrence per year

With regard to determination of the number of risk occurrences per year the following three
theoretical probability distributions are commonly used:
 Binomial probability distribution

 Normal probability distribution

 Poisson probability distribution


n!


P (r) =
r!(n  r)!
x r (q)nr


Where:
n = number of exposure or number of items exposed to risk
r= number of accidents (risk)
q= (1-P) = probability of not getting accidents


The Binomial Probability Distribution
Assumptions:
 A firm has n – units independently exposed to loss

40
  Each units can experience at most one loss during the year
 The probability that any particular unit will suffer a loss during the year is P and the
probability that the firm will suffer “r” loss during the exposure period is :

Example: Suppose a company operates four delivery trucks. Again assume that if an accident
happens to a particular trucks, it becomes a total loss and suppose further that new trucks are
purchased at the beginning of every year to replace the lost one .Records regarding the
operation of the company over the last four years shows the following information ( assume
also the value of one truck is 6,000dollar )

Years Number of trucks Number of Monetary loss in dollar

accidents
1 4 2 12,000
2 4 2 12,000
3 4 1 6,000
4 4 3 18,000
Total = 4 16 8 48,000

Based on the above information:

 Average ( expected ) monetary loss per accident
= total monetary loss
Total number of accidents
= 48,000 =6,000 dollar

41
  Probability of accident = total number of accidents = 8/6=0.5
Total number of cars

 Mean or average or expected monetary loss per year

= Total monetary loss
Total number of years
= 8/4 = 2 accidents per year

Or average monetary loss per accident x average number of accidents per year
= 6,000 x 2= 12,000 dollar

 Standard deviation = nxpxq = 4x0.5x0.5 =1

Where:
P = probability of getting accidents.
q= probability of not getting accidents.
n= number of items exposed to risk.

Probability distribution of the number of accidents

P (0) =
n!
r!(n  r)! x  r xqnr
4!
= x 0.5 0 x 0.5 4
0!(4  0)!

= 0.0625
4!
P (1) = x 0.51 x 0.541
1!(4 1)!
24
= x 0.5 x 0. 125
6
= 0.25

42
 4!
P (2) = x 0.5 2 x 0.5 42
2!(4  2)!

24
= x 0.25 x 0.25
4
= 0.375

4!
P (3) = x 0.5 3 x 0.5 43
3!(4  3)!

24
= x 0.125 x 0.5
6
= 0.25

4!
P (4) = x 0.5 4 x 0.5 44
4!(4  4)

43
 24
= x 0.0625 x 1
24
= 0.0625

N.B:
 P (0) + P (1) + P (2) + p (3) + P (4) =1
 The expected number of accident is two.








Number of accidents Probability Expected number of
accidents

0 0.0625 0
1 0.25 0.25
2 0.375 0.75
3 0.25 0.75
4 0.0625 0.25
Sum 1.00 2.00

 The standard deviation is nxpxq = 4x0.5x0.5 =1

 The probability that the firm will suffer (face) some accident is
1-0.0625=[Link] probability is so high that the risk manager should take appropriate
measures to handle the risk.

43
Normal Distribution
The risk manager may assume that the numbers of accidents or total annual monetary losses
are approximately normally distributed. Under such circumstances, he/she may use normal
distribution in measuring the number of accidents or total annual monetary losses.

If observations are normally distributed, the risk manager will have a good insight of the size of
possible losses at much greater ease. This is because the normal distribution can be well
explained by identifying only two parameters, the mean and the standard deviation.

The normal distribution is particularly attractive probability distribution because it is relatively

simple to determine the probability that the variable will fall within a certain range of values.
Normal distribution has the following properties: Approximately,
- 68.27% of the variable or observations will fall within the range bounded by expected value or
mean plus or minus one standard deviation.
-95.45% of the observation will fall within plus or minus two standard deviation.
-99.74% of the observation will fall within plus or minus three standard deviation

3 -2 -1 0 1 2

x  
Z=

44
Where Z=are under the normal curve
X = Actual out come
 = Number of standard deviation form the mean
 = expected out come
EXAMPLE: based on the previous examples, which have a mean of 560 and a standard deviation
of 1108, attempt the following questions
a) What is the probability that the actual out come will be less or equal to 1,668?
Solution:

x  
Z=

1668  560
= =1
1108
P(X  1668) = P (Z  1) =0.5+ ½(0.6826)
Z= 0.8414
This is the probability that the actual out come will be 1668 or less

b) What is the probability that the actual out come will be less than or equal to 1,000?

Solution:
P(x  1,000)?

45
 x  
Z=

1,000  560
Z=
1108
Z = 0.39
P(x  1,000) = P (Z  0.4) = P (-  to 0.4)
= 0.5+0.1554
= 0.6554

b) What is the probability that the actual out come will be greater than or equal to 2,000?

Solution :
P(x  2,000)?

x  
Z=

2,000  560
Z= = 1.3
1108
P(x  2,000) = P (z  1.3)
= 0.5- P (0 to 1.3)
= 0.5-0.4032
= 0.0968

Number of Occurrences per Year and the Loss per Occurrence

To find out number of accidents , arrivals , achievements and occurrence in a given period we
use Poisson distribution. Poisson distribution consists of the mean and standard deviation
Assumption:
1. The value of each object may not be equal.
2. A particular object can suffer more than one accident

46
 3. There will be no replacement of objects or property

Formula :

m r xem
P(r) =
r!

Where:
m =mean
e = 2.71828
r! = r factorial
r = number of occurrences

The standard deviation of this distribution is m according to statistical theory and empirical
verification. The greatest advantage of Poisson distribution is that to use it one must estimate
only the average number of occurrences that is estimation of the means alone.

Example:
The data presented below represents the number of cars of similar types operated by a firm in
each year, the corresponding number of accidents occurred and the total monetary losses
incurred in connection with the accidents are shown below;

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Year Number of cars Number of Amount of loss in
accidents birr

1 6 1 2,500

2 8 2 4,200

3 10 2 4,500
4 11 3 6,000
5 15 2 6,500
Sum 50 10 23,700
Mean 50/5=10 10/5= 2 23,700/5=4,740

Suppose in the year six the number of cars increased to 20 , the risk manager wants to
construct a probability distribution on the base of data collected above.

Answer:
To construct the probability distribution first,. find the mean number of accidents

Mean = number of observation (n) times probability of getting an accident

total  numberof ..accidents

Probability of an accident =
total..number..of ..cars
10
= ==0.2
50

Then,
 Mean (m) = 20 x 0.2 = 4

 Standard deviation ( ) = m = 4 =2

 Coefficient of variation (CV) = = 2/4 =0.5, the risk associated with this distribution is
m
calculated by coefficient of variation
48
Having the above information at hand, the probability distribution can be constructed as
follows:
Number of accidents Amount of loss Probability
0 0 0.0183
1 2,370 0.0732
2 4,740 0.1465
3 7,110 0.1954
4 9,480 0.1954
5 11,850 0.1562
6 14,220 0.1042
7 16,590 0.0595
8 18,960 0.0595
9 21,330 0.0132
10 23,700 0.0053
11 26,070 0.0019
12 28,440 0.0006
13 30,810 0.0002

Total probability 0.99998

Based on the above probability distribution answer the following question

a) What is the probability that there will be three or more accidents?
b) What is the probability that there will be ten or more accidents?
c) What is the probability that number of accidents will be three or more but less than
ten?

Answers:
a) P(r  3)=1- P(0)+p(1)+P(2)
=1-0.0183+0.0732+0.1465

49
 =1-0.238
= 0.762

b) P(r  10)=P(10)+P(11)+P(12)+P(13)
= 0.0053+0.0019+0.006+0.0002
= 0.008
c) P(r  3 but r  10)
=P(r  3) - P(r 10)
=1-P(0) +P(1)+P(2) – p(11)+P(12)+P(13)
= 0.0762- 0.0027
= 0.7593
3.2.3 Selecting the Appropriate Tools of Risk Management
Dear Student! Would you discuss methods of handling risk from your own experience?

Well! According to Trieschmann, Hoyt and sommer (2005, pp.76-85), the four basic methods
available for handling risks are risk avoidance, loss control, risk retention and risk transfer. After
the risk manager has identified and measured the risk faced by his or her firm, he or she must
decide to handle them. There are two basic approaches.

First, the risk manager can use risk control measures to alter the exposure in such a way as
1. To reduce the firms expected property , liability , and personnel losses, or
2. To make the annual loss experience more predictable.

These risk control techniques includes:

1. Avoidance
2. loss prevention and reduction measures

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 3. Separation or diversification
4. Combination
Risk financing techniques- risk manager can use risk financing technique (measure) to finance
the losses that do occur. Funds may be required to repair or restore damaged property, to
settle liability claims or to replace the services of disabled or deceased employees.
The tools in this second category include:
1. Retention
2. Self insurance
3. Noninsurance transfer
4. Insurance

1. Risk Control Techniques

Dear student! What does loss control mean?

1.1 Avoidance
One way to avoid a particular pure risk is to avoid a property, person or activity with which
the exposure is associated by
Refusing to assume it even momentarily or
Refusing an exposure assumed earlier.
Example
- a firm can avoid a flood loss by not building a plant in a flood plain area ( avoidance
by refusing to assume at the very beginning )
- A firm that produce a highly toxic product may stop manufacturing that product (
avoidance by refusing an exposure assumed earlier)
- An individual can avoid third party liability by not owing a car.
- A product liability can be avoided by dropping the product
- Leasing avoids the risk originating from property ownership.

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The major advantage of avoidance is that the chance of loss is reduced to zero if the loss
exposure is not acquired. In addition, if an existing loss exposure is abandoned, the possibility
of loss is either eliminated or reduced because the activity or the product that could produce a
loss has been abandoned.
The major down side attributed to this technique is that it may not be possible to avoid all
losses.
For example – A company can not avoid the premature death of key
executive
-A business has to own vehicles, buildings, machinery,
inventory etc with out them operation would be impossible
Under such circumstances avoidance is impossible.

 Avoidance through abandonment is to be distinguished from transfers of the property,

person, or activity to someone else. For example toxic product manufacturer might have
sold its business to some other company. These transfers pass the risk to some one else,
risk avoidance discontinues the source of risk .
 Avoidance, whether it is implemented by abandonment or by refusal to accept the risk,
should also be distinguished from loss- control measures. Loss control measures assume
that the firm will retain the property, person or activity creating the risk but the firm will
conduct its operations in the safest possible manner.

The following are important characteristics of avoidance:

 Avoidance may be impossible (it may not be possible to avoid all loss). For example,
a paint factory can avoid losses arising from a production of paint. However, without
any paint production, the firm will not be in business.
 The potential benefits to be gained from employing a certain person , owing a piece
of property , or engaging in some activity may so far over weight the potential loss and

52
 uncertainties involved that the risk manager will give little consideration to avoid the
exposure.
For example, most business would find it almost impossible to operate with out owning
or renting cars. Consequently they consider avoidance to be an impractical approach.

 Avoiding a risk may create another risk. For example a firm may avoid the
risk associated with air shipments by substituting train and truck shipments. In
the process however, it has created some new risks.

1.2 Loss Prevention and Reduction Measures

These measures refer to the safety actions taken by the firm to per event the occurrence of
a loss or reduce its severity if those losses have already occurred.

Loss reduction measures try to minimize the severity of the loss once the peril happened for
example, car accident can be prevented or reduced by having good roads, better lights and
sound traffic regulation and control, fast first aid service and the like.

Loss prevention (LP) and loss reduction (LR) measures must be considered before the risk
manager considers the application of any risk financing measures. Following are some
examples of loss prevention and reduction plans.
Loss prevention measures:
 Constructions using fire insensitive materials
 Automatic smoke detector , fire alarm
 Burglary alarm in costly business such as jewelry , diamonds
 Tight quality control to prevent risk of product liability
 Multiple suppliers , buffer stocks
 Adequate lighting , ventilation ,special work clothes to prevent industrial
accidents

53
  Electronic metal detectors to check passengers for arms and explosives in the
airline business.
 Regular inspection of machinery to prevent explosions, breakdowns etc.
 Warning posters (NO SMOKING!! DANGER ZONE!!)
Loss reduction measures:
Speed limit for motor vehicles
First aid kit
 Fire alarm
 Evacuation of people from earth quick prone area

Appropriate measures taken to prevent accidents bring benefits not only to the firm, but also to
the society as well. For example a distraction of inventory of a firm, could be a total loss to the
firm in particular. The society faces an economic loss because those goods are not more
available to people. Thus, the importance of LP and LR measures should not be underestimated
by a firm.

To design effective LP and R measures, it may be help full to identify the cause of accidents.
Data should also be kept regarding accidents occurred. The cause of these accidents must be
investigated. LP and R measures entail costs. These costs include expenditures for the
acquisition of safety equipments and services, operating expenses such as salary expenses to
inspectors, safety engineers and other employee’s engaged in safety work.
Other costs are also incurred in connection with safety training and seminars. The risk manager
will have to design the LP and R measures in the most efficient way in order to minimize such
costs without reducing the desired safety level.

1.3. Separation
Separation of the firm’s exposure to loss instead of concentrating them at one location where
they might be involved in the same loss is the third risk control tool.

54
For example – instead of placing its entire inventory in one warehouse the firm may elect to
separate this exposure by placing equal parts of the inventory in ten widely separated
warehouses.
- Dispersing work operations in such a way that explosion or other catastrophe
would not injure more than a limited number of employees

Other things being equal, because of law of large number, this increase reduces the risk, thus
improving the firm’s ability to predict what its loss experience will be.
1.4 Combination or Diversification.
Combination or pooling makes loss experience more predictable by increasing the number of
exposure units .The difference is that, unlike separation, which spreads a specified number of
exposure units, combination increases the number of exposure units under the control of the
firm.

In case of firms, combination results in pooling of resources of two or more firms. One way a
firm can combine risks is to expand through internal growth .For example a taxicab company
may increase its fleets of automobiles .Combination also occur when two firms merge or when
one acquires the other. The new firm will have more buildings, more automobiles, and more
employees than either of the original companies. This leads to financial strength, there by
minimizing the adverse effect of the loss.

Diversification is another risk handling tool. Most speculative risk in business can be dealt with
diversification. Businesses diversify their product line so that a decline in profit of one product
could be compensated by profit from others. Fore example – farmers diversify their products
by growing different crops on their land. Diversification, however, has limited use in dealing
with pure losses.
2. Risk Financing Techniques
2.1 Retention

55
Retention means that the firm retains part or all of the losses that resulted from a give loss
exposure. The source of the fund is the organization itself, including borrowed funds that
the organization must repay.

 Retention may be active / conscious / planned or passive / unconscious / unplanned.

Retention is active /planned when the risk manager consider other methods of handling the
risk and consciously decides not to transfer the potential losses.

Retention is passive or unplanned when the risk manager is not aware that the exposure
exists and consequently does not attempt to handle the loss exposure. By default the
organization has elected to retain the risk associated with that exposure.

A related form of retention occurs when the risk manager properly recognize the exposure
but underestimate the magnitude of potential losses (failure to recognize the loss unit
concept).

Retention can be effectively used in a risk management program when three conditions
exist.
 When no other methods of treatment are available. Insurers may be unwilling to write a
certain type of coverage, or the coverage may be too expensive. Non insurance transfer
may not be available. In addition, although loss control can reduce the frequency of loss, all
losses can not be eliminated. In this case, retention is the residual method.
 When the worst possible loss is not serious. For example, physical damage losses to
automobiles in a large firm’s fleet will not bankrupt the firm if automobiles are separated by
wide distances and are not likely to be simultaneously damaged.
 When losses are highly predictable. Retention can be effectively used for workers
compensation claims, physical damage loss to automobiles and shoplifting losses. Based on
past experience, the risk manager can estimate a probable range of frequency and severity

56
of actual losses. If most losses fall within that range , they can be budgeted out of the firm’s
income .

2.2 Self-insurance

Self-insurance is a special form of planned retention by which part or all of a given loss
exposure is retained by the firm. A better name for self-insurance is self-funding, which
expresses more clearly the idea that the losses are funded and paid by the firm.

Risk retention – planned or unplanned - should not be confused with the concept of self-
insurance. Although self-insurance requires risk retention, it implies an attempt by the
business to combine a sufficient number of e its own exposures to predict the losses
accurately. Furthermore a self insurance plan implies that adequate financial arrangements
have been made in advance to provide funds to pay for losses if they occur. Self insurance
plans are distinguished from other insurance operations by having the pooling of the
exposure and funding of the costs of losses takes place within one business entity. Unless
payments to self insurance plans are calculated scientifically and paid , a true self insurance
system does not exist.

2.3 Non insurance transfers

These are methods other than insurance by which a pure risk and its potential financial
consequences are transferred to another party. Transfers may be accomplished in two
ways. These are:

 Transfer of the property or an activity.

The property or an activity responsible for the risk may be transferred to some other person
or group of persons.
Fore example

57
 - A firm that sells one of its building transfer the risk associated with owner ship of
the building to the new owner.
- A contractor who is concerned about possible increase in the cost of labor and
materials needed for electrical work on the job to which he or she is already
committed can transfer the risk by hiring a subcontractor for this portion of the
project.

This type of transfer, which is closely related to avoidance through abandonment, is a risk
control measure because it eliminates a potential loss that may strike the firm. It differ from
avoidance through abandonment is that to transfer the risk the firm must pass it to some one
else.

 Transfer of the probable loss(Hold harmless agreements)

The risk but not the property or activity, may be transferred.
Fore example
- A retailer may insist on a hold harmless provision in his or her purchase contracts
under which the manufacturer agrees to indemnify the retailer for any liability
sustained because of defective products unless the defect was caused only by the
retailer’s negligence.
- A publishing firm may insist a hold harmless clause in a contract , by which the
author, not the publisher , is held legally liable if the publisher is sued for plagiarism
- A contractor may require sub contractors to provide the contractor with liability
protection if they are sued because of the subcontractor’s activities.

Advantages and Disadvantages of Non Insurance Transfers

Advantages
 The risk manager can transfer some potential losses that are not commercially
insurable
 Non insurance transfer mostly costs less than insurance

58
  The potential loss may be shifted to some one who is in a better position to exercise
loss control.

Disadvantages
 The transfer of a potential loss may fail because the contract language is ambiguous
.Also there may not be court precedents for the interpretation of a contract that is
tailor-made to fit the situation.
 If the party to whom the potential loss is transferred is un able to pay the loss , the firm
is still responsible for the claim
 Non insurance transfer may not always reduce insurance costs, since an insurer may not
give credit for the transfer.

2.4. Insurance
- Insurance is a device by means of which the risk of two or more persons or firm’s are
combined through actual or promised contributions to a fund out of which claimants are paid.
It is appropriate for loss exposures that have low probability of loss but the severity of loss is
very high.

If the risk manager uses insurance to treat certain loss exposures five key areas must be
emphasized. They are as follows:
 Selection of insurance coverage
 Selection of an insurer
 Negotiation of terms
 Dissemination of information concerning insurance converge
 Periodic review of insurance program

59
First the risk manager must select the insurance coverage needs. Since there may not be
enough money in insurance budget to insurance all possible loss, the need for insurance can be
divided in to several categories depending on importance. One useful approach is to clarify the
need for insurance in to three categories.
i. Essential insurance – includes those coverage required by law or by contract , such as
workers compensation insurance
ii. Desirable / important insurance – is a protection against losses that may cause the firm
financial difficulty, but not bankruptcy.
iii. Available /optional insurance – is coverage for slight losses the would merely
inconvenience the firm. Optional insurance coverage includes those that protects
against losses could be meet out of the existing asset or current income.

Second, the risk manager must select an insurer or several insurers. Several important factors
come into play here. These include:
 Financial strength of the insurer
 Risk management services provided by the insurer
 Cost and terms of protection , etc

The insurers’ financial strength is determined by size of policy owner’s surplus, underwriting
and investment results, adequacy of reserves for outstanding liabilities, type of insurance
written and the quality of management.

The risk manager must also consider the availability of risk management services in selecting a
particular insurer. An insurance agent or broker can provide the desired information concerning
the risk management services available from different insurers. Such services include assistance
in identifying loss exposure, in loss control, and in claim adjustment.

The cost and term of insurance protection can also be considered. All other factors being equal,
the risk manager would prefer to purchase insurance at the lowest possible price.

60
Third, after the insurer or insurers are selected, the terms of the insurance contract must be
negotiated. If printed polices, endorsements, and forms are used, the risk manager and insurer
must agree on the documents that will form the base for the contract. If a specially tailored
manuscript policy is written for the firm, the language and meaning of the contractual
provisions must be clear to both parties. In any case, the various risk management services the
insurer will provide must be clearly stated in the contract.

Third, if the firm is large, the premiums must be negotiable between the firm and insurance
company. In many cases, an agent or broker will be involved in the negotiations.

Fourth, information concerning insurance coverage must be disseminated to others in the firm.
The firms employees and managers must be informed about the insurance coverage , the
various records that must be kept , the risk management services that the insurer will provide
,an d the changes in the hazards that could result in suspension of insurance . And, of course,
those persons responsible for reporting a loss must be informed. The firm must comply with
policy provisions concerning how notice of a claim is to be given and how the necessary proofs
are to be presented.

Finally, the insurance program must be periodically reviewed. The entire process of obtaining
insurance must be evaluated periodically. This involves an analysis of agent and broker relation
ships, coverage needed, cost of insurance, quality of loss –control services provided, whether
claims are paid promptly, and numerous other factors. Even the basic decision whether to
purchase insurance must be reviewed periodically.

Advantage of insurance
The use of commercial insurance in a risk management program has the following advantages

61
The firm will be indemnified after a loss occurs. The firm can continue to operate; there may
be little or no fluctuation in earnings.

Uncertainty is reduced, which permits the firm to lengthen its planning horizon. Worry and
fear are reduced for management and employees, which should improve their performance
and productivity.

Insurance can provide valuable risk management services, such as loss –control services,
exposure analysis to identify loss exposures, and claim adjusting.

Insurance premiums are income tax deductible, as a business expense.

Disadvantages of insurance
The use of insurance also entails certain disadvantages and costs
 The payment of insurance premium is a major cost, since the premium consists of a
component to pay losses, an amount for expenses, and allowance for profit and contingencies.
There is also an opportunity cost. Under the retention technique discussed earlier, the premium
could be invested or used in the business until needed to pay claims. If insurance is used
premium must be paid in advance.

 Considerable time and effort must be spent in negotiating the insurance coverage. An
insurer or insurers must be selected, policy terms and premiums must be negotiated, the firm
must cooperate with the loss- control activity of the insurer, and a proof of loss must be filed
with the insurer following the loss.

 The risk manager may have less incentive to follow a loss –control program, since the insurer
will pay the claim if a loss occurs. Such a lax attitude towards loss control could increase the
number of noninsured losses as well.
Which Method Should Be Used?

62
In determining the appropriate method or methods for handling losses, a matrix can be used
that classifies the exposure according to severity and frequency .The following matrix can be
useful in determining which risk management technique should be used.

Loss frequency Loss severity Appropriate risk

management technique
Low Low Retention
High Low Loss control and retention
Low High Insurance
High High Avoidance

The first exposure is characterized by both low frequency and low severity. This type of
exposure is best handled by retention, since the loss occurs infrequently and, when it does
occur, it seldom cause financial harm
Example – Theft of a secretary’s dictionary.

The second type of exposure is characterized by high frequency and low severity of losses is
more serious.
Example – Physical damage to automobiles.
- Workers compensation claim.
- Food spoilage
- Shoplifting
Loss control should be used here to reduce the frequency of loss. In addition since losses occur
regularly and are predictable, the retention technique can also be applied.

The third type of loss exposure can be met by insurance. Insurance is best suited for low
frequency and high severity of losses. High severity means that a catastrophic potential is

63
present, while a low probability of loss indicate that the purchase of insurance is affordable or
economically feasible.
Example – Fire
- Explosion
- Liability law suits.
The risk manager could also use a combination of retention and commercial insurance to deal
with these exposures.

The fourth and most serious type of exposure is one characterized by both high frequency and
high severity. This type of exposure is best handled by avoidance.

Example – if you have been drinking in a bar and attempt to drive home, the chances are high
that you will be in an accident or kill or seriously injure some one. This loss exposure can be
avoided by not driving when you drink or by having a designated driver to take you home.
3.2.4 Implementing and Monitoring the Risk Management Program

Dear learner! How do you think should risk management be implemented to achieve its
objectives?

Implementing a risk management program begins with the development of a risk management
policy statement. However, a policy statement alone is not enough. It should be supported by
a manual which details risk management process. It is also highly essential that the risk
manager works in collaboration with other departments of the organization. Finally, it is

64
important to review risk management programs since organizations operate in a dynamic
environment where change is a fact of life.

Risk management policy statement

Dear distance learner! What is a policy? Why policies are developed? Define policy in your own
terms and explain the benefits of a policy for risk management.

Simply put, policies are broad guidelines for decision making. Thus, a risk management policy is
necessary in order to effectively implement a risk management program. A risk management
policy statement serves the following purposes:
 It specifies the risk management objectives of the firm. The policy statement clarifies
which of the pre-loss and post-loss objectives of risk management are pursued by a
given organization.
 The policy statement is used as a guideline for a firm’s top management to
understand the process of risk management.
 the policy clarifies the duties, responsibilities of the risk manager. In addition, it
defines the risk manager’s authority and standards of performance expected of
him/her.
In addition to broad guidelines provided by risk management policy statement, it may be
essential to develop a risk management manual. The manual describes the risk management
program in more detail than the policy statement. It can also be used to train new employees
who will participate in risk management programs. Moreover, a risk management manual
precisely states the objectives and responsibilities of risk management and different techniques
of risk management used by the firm.

Cooperation with other departments

65
Dear student! As you know, today’s organizations operate in a systematic manner. That is, their
functional departments (subsystems) operate in an interdependent and cooperative manner to
achieve synergistic outcomes- outcomes that are better than if the departments operate
independently. The same is true about the operations of an effective risk management. The
cooperation of other departments in the organization is extremely important for identifying
pure risks facing the firm and for selecting appropriate methods of handling risks.
The following are, but some of, the ways other departments can cooperate in risk
management process:

Accounting and finance – By implementing internal accounting controls, employee fraud and
theft of cash can be reduced.

 Marketing – Accurate packaging and labeling can prevent liability risks. Selecting and using
safe distribution procedures can reduce accidents.
 Production – quality control done by production department can reduce production of
defective goods and, consequently, reduce liability law suits. Accidents in work places can also
be reduced by implementing effective occupational safety and health programs.
 Personnel – this department can contribute a lot in reducing liability risks arising from
employee benefit provision, and the firm’s hiring, promotion and dismissal policies.

The above list indicates how the risk management process involves the entire firm. Indeed with
out the active cooperation of other departments, the risk management process will be a failure.

Periodic Review and Evaluation

To effective, the risk management program must be periodically reviewed and evaluated to
determine if the objectives are being attained. In particular, risk management costs, safety
programs and loss prevention programs must be carefully monitored.

66
Loss records must be examined to detect any changes in frequency and severity. In addition,
new departments that affect the original decisions of handling a loss exposure must be
examined.

Finally the risk manager must determine if the firms over all risk management polices are being
carried out, and if the risk manager is receiving the total cooperation of the other departments
in carrying out the risk management function.

Summary

 Risk management is a process of identifying, analyzing and treating pure loss exposures faced

by a firm. It deals with both insurable and uninsurable pure risks.

 Risk management has several important pre-loss and post-loss objectives. The pre-loss
objectives include dealing with losses in the most economical manner, reducing worry and fear
as a result of the presence of risk, and meeting legal obligations. Post loss objectives of risk
management include enabling organizations to survive, have stable earnings, continue
uninterrupted operation, grow, and meet their social responsibility objectives.

 There are four major steps in risk management process. They are summarized below:

Step 1. Identifying loss exposures- To identify all loss exposures faced by a firm the risk
manager should first develop a checklist of exposures which indicate losses that may happen to
any firm. In addition, the risk manager may use insurance checklists to identify insurable pure
risks. After developing loss exposure checklist, the manager should identify which of the risks
on the checklist are actually faced by the firm. This can be determined through the help of risk
analysis questionnaires; analyzing financial statements, process flow charts, internal and
external environmental factors affecting the firm; through interaction with other departments;
and by reviewing historical record of losses in the firm.

67
Step 2. Analyzing loss exposures- During this step, the risk manager tries to estimate or
measure the frequency and severity of losses. There are subjective and objective (statistical)
methods of estimating loss frequency and severity. However, if data is available, it is preferable
to use the more precise statistical estimates. The risk manager should understand the basic
rules of probability and probability distributions. In this unit, the application of probability and
probability distributions in estimating the followings have been discussed:
a) The probability that a business will incur some Birr loss
b) The probability that a loss exceeding some amount of Birr would occur
c) Yearly average loss or expected total Birr loss or average annual Birr loss
d) Risk or variations from expected outcome
e) Number of risk occurrence per year and the loss per occurrence

Step 3. Selecting the most appropriate techniques for treating loss exposures- Based on
his/her estimate of the frequency and severity of a loss the risk manager should choose the
most appropriate technique/s for treating each loss exposure. There are two broad categories
of risk handling techniques: Risk control techniques and risk financing techniques.

Risk control techniques are aimed at reducing the severity and/or frequency of losses. These
techniques include avoidance, loss prevention and reduction measures, separation or
diversification, and combination.

Risk financing techniques, on the other hand, are aimed at financing (recovering from) losses
that already occur. These techniques include retention, self insurance, non insurance transfer,
and insurance.

Step 4. Implementing and monitoring the risk management process- Implementing a risk
management program begins with the development of a risk management policy statement.

68
 The policy statement provides a broad guideline about risk management objectives of a firm,
authority and responsibilities of the risk manager; and risk management process.

The policy statement should be supported by a manual which details risk management process.
In addition, the risk manager should work in collaboration with other departments- like
accounting, production, marketing, and human resources- to identify risks and properly
implement the risk management program of the organization. Finally, it is important to conduct
periodic review of the risk management programs to consider changes in severity and/or
frequency of losses, involve other departments of the firm, to ensure that risk management
policies are effectively implemented and risk management objectives of the firm are achieved.

Review Questions

1) What is risk management?

2) Explain the objectives of risk management both before and after a loss occurs
3) Briefly describe the steps in risk management process
4) identify the sources of information that can be used to identify loss exposures faced by a firm
5) What are the two broad categories of risk handling techniques?
6) Explain the meaning of risk control.
7) Explain the following risk control techniques:
Avoidance:
Loss prevention:
Loss reduction:
Combination:
Separation:
8) Explain the following risk financing techniques:
Retention:
Non-insurance transfers:

69
 Insurance:
9) ABC Company has 64 departments stores scattered all over the country. The risk manager
doesn’t know the probability distribution of the total annual monetary losses from theft at all
locations but estimates the average monetary loss per year to be $ 80,000 with a standard
deviation of $ 15,000. (check your answers below)

a) If the risk manager assumes a normal probability distribution what is the probability that
theft losses in the next year exceed $ 95,000?
b) If ABC wants to increase its stores to 90, determine:
i. the new average monetary loss
ii. the new standard deviation
iii. risk related to the mean
iv. confidence interval for losses included with in two standard deviations from the mean

10) Assume that the chance of occurrence is 1/10, so what number of exposures must the risk
manager possess for the probability to be 95.4 % that the actual number of occurrences will fall
within the range whose boundaries are the expected number of occurrences plus or minus
50%? (check your answers below)

Answers for question numbers 9 and 10.

Answer for question 9

a) Given:  =80,000
SD= 15,000
Required: P(X 95,000)

X   95,000  80,000
Z= = =1
 15,000

P(X  95,000)=P(Z  1)= 0.5-P(0 to 1)

70
 = 0.5- 0.3414
=0.1586 or 15.86%

b) i. the new average monetary loss

n2
New average monetary loss = previous mean x
n1

Where:
n2 = Number of property the company will have in the future
n1= Number of property that the company had in the past
n2
There fore, the New average monetary loss = previous mean x
n1

= 80,000 x 90/64
= $112,500
ii. The new standard deviation

n2
The new standard deviation=previous SD x
n1

90
The new standard deviation = 15,000 x
64
= $ 17,788
iii. Risk related to the new mean

 17,788
Risk related to the new mean = x100   15.8% or 0.1581
 112500

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 iv. Confidence interval

New mean  2(SD)

New mean  2(17,788)
112,500  2(17,788)
112,500  35576
76924 to 148,076

Answer for exercise -2

50% of mean =  2SD

50
xnxp  2 nxpxq
100

50 1 9
x n x p =2 nx x
100 10 10

2
1 n   
2

 9
 x   2x nx 
2 10   10 



n2
 4x 9n
100
400
n2 36n

400 100

2
100 n =400x36n

72
 100n2 14400n
 n=144 exposure units
100n 100n
n2
The new standard deviation=previous SD x
n1

References
Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company
,USA Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc
Graw Hill company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002
Jhon Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw
Hill company ,USA
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA
Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA
Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA
r, Harold and W. Jee ,Risk Management and Insurance: Perspectives in
my,2007, Black well Publishing,Australia
mann, Hoyt and sommer,Risk Management,12 th ed. 2005, South Western ,US A

73
 Unit Three

Insurance contracts

Learning objectives

After completion of this unit, you will be able to:

74
 Understand the meaning of insurance and insurance contract

Understand how an insurance contract is to be effected

Explain basic characteristics of insurance contract

Elaborate the basic features of an insurance contract

Describe the basic requirements of an insurance contract

Section one

Understanding the meaning and general features of insurance contacts

Section overview

The term insurance can be defined in different ways however what the definition may be ,
insurance contracts are agreements to be made between one party called the insured who is
also called customer of an insurance company and another party called the insurer-the
insurance company in which case the insured pays premium for and transfers accidental risks to
an insurance company which in turn accepts the stated risk in return for collecting premium
and agrees to compensate accidental risks faced by the insured ,provided the accidental risk
has occurred with in the stated period of time. This unit will present you the basic definitions
of insurance contracts from different perspectives, its basic features ,parts advantages and
disadvantages as well.

Section objectives

At the end of this section, you will be able to:

Outline the basic concepts of insurance and insurance contract

75
Point out the parties who engage in the insurance contract

Elaborate the basic characteristic of insurance contract

Section outlines

1. Insurance contract
2. General characteristic of insurance contracts

3.1.1 Insurance contract

Dear students! Would you define the term insurance contract from your own
experience?

Well !!! In insurance, an insurance contract is a contract (generally a standard form contract)
between the insurer and the insured, known as the policyholder, which determines the claims
which the insurer is legally required to pay. In exchange for payment, known as the premium,
the insurer pays for damages to the insured which are caused by covered perils under the policy
language. Insurance contracts are designed to meet specific needs and thus have many features
not found in many other types of contracts. Since insurance policies are standard forms, they
feature boilerplate language which is similar across a wide variety of different types of
insurance policies.

The insurance contract is generally an integrated contract, meaning that it includes all forms
associated with the agreement between the insured and insurer In some cases, however,
supplementary writings such as letters sent after the final agreement can make the insurance
policy a non-integrated contract One insurance textbook states that "courts consider all prior
negotiations or agreements ... every contractual term in the policy at the time of delivery, as

76
well as those written afterwards as policy riders and endorsements ... with both parties'
consent, are part of written policy". The textbook also states that the policy must refer to all
papers which are part of the policy. Oral agreements are subject to the parol evidence rule,
and may not be considered part of the policy. Advertising materials and circulars are typically
not part of a policy. Oral contracts pending the issuance of a written policy can occur.

Some more definitions of an insurance contract

A) Insurance is the process of transferring unexpected risks/accidents/losses from an

individual to the group of insured persons who posses similar exposures and who
are also prone to the same peril
B) Insurance is a protection against accidental loss of assets, life, some businesses

resources and income.

C) Insurance is a process by which an individual pays premium for and then transfer an

expected risks to an insurance company which in turn promises to accept and

reimburse risks faced by an insured customer.

D) Insurance, in law and economics, is a form of risk management primarily used to

hedge against the risk of a contingent loss. Insurance is defined as the equitable
transfer of the risk of a loss, from one entity to another, in exchange for a premium,
and can be thought of as a guaranteed and known small loss to prevent a large,
possibly devastating loss. An insurer is a company selling the insurance; an insured
or policyholder is the person or entity buying the insurance.

The insurance rate is a factor used to determine the amount to be charged for a certain
amount of insurance coverage, called the premium. Risk management, the practice of
appraising and controlling risk, has evolved as a discrete field of study and practice.

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E) Insurance is a process of predicting, pooling, spreading and then sharing equally accidental
risks faced by few unfortunate individual among the entire group of insureds who belong to the
same insurance category and also who posses similar/related exposures.

N.B Insurance is a device by means of which the risk of two or more persons or firms are
combined through actual or promised contribution (i.e premium) to a fund out of which the
claimants are paid and reimbursed accordingly.

From insurers point of view ,insurance is a combination of unexpected losses exposures and
from insureds point of view, it is a transfer of accidental risks from the individual to the group.

3.1.2 General characteristics of an insurance contract

The insurance contract is a contract whereby the insurer will pay the insured (the person whom
benefits would be paid to, or on the behalf of), if certain defined events occur. Subject to the
"fortuity principle", the event must be uncertain. The uncertainty can be either as to when the
event will happen (i.e. in a life insurance policy, the time of the insured's death is uncertain) or
as to if it will happen at all (i.e. in a fire insurance policy, whether or not a fire will occur at all).
Generally ,the basic characteristics of insurance contracts are as follow

1. Contract of adhesion

 Insurance contracts are generally considered contracts of adhesion because the insurer
draws up the contract and the insured has little or no ability to make material changes
to it. This is interpreted to mean that the insurer bears the burden
 if there is any ambiguity in any terms of the contract. Insurance policies are sold without
the policyholder even seeing a copy of the contract.

2. Aleatory contracts

78
 Insurance contracts are aleatory in that the amounts exchanged by the insured and
insurer are unequal and depend upon uncertain future events.

3. Unilateral contracts

 Insurance contracts are unilateral, meaning that only the insurer makes legally
enforceable promises in the contract. The insured is not required to pay the premiums,
but the insurer is required to pay the benefits under the contract if the insured has paid
the premiums and met certain other basic provisions.

4. Contract of utmost good faith

 Insurance contracts are governed by the principle of utmost good faith which requires
both parties of the insurance contact to deal in good faith and in particular it imparts on
the insured a duty to disclose all material facts which relate to the risk to be covered.

5. Risk transfer

. Risk transfer means shifting of those risks which have the chance of loss(no gain) or no
loss(neutral) i.e pure risks from the insured to the insurer, who typically in a strong financial
position to pay the losses than the insured under consideration.

6. Indemnification

. Indemnification means that the insured is restored to his /her approximate financial
position even before the occurrence of accidental loss i.e. insurance is a device by which
insured get compensation by the time they incur unexpected loss during the specified
period of time in which case the insurance contract/policy is in force.

7. Payment of fortuitous loss

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 A fortuitous loss is one of the most important factors considered by insurance companies
and refers to losses that happens accidentally, unexpectedly or the one that occur by
chance.

8. Pooling of losses

Pooling refers to the collection of unexpected losses and the spreading of those losses
incurred by few unfortunate insured over the entire group and hence in doing so the
average or expected loss is substituted for the actual loss. Besides, pooling involves the
grouping of a large number of similar exposure units under one insurance

contract so that the law of large numbers can operate to provide a substantially accurate
prediction of future losses . ideally, there should be large number of similar ,but not
necessarily identical exposures units that are prone to the same/related peril.

Thus pooling implies,

i. the sharing of losses by the entire group

ii. prediction of future losses with some accuracy based on the law of large
numbers

N. B The law of large numbers state that the greater the number of exposure units,
under one insurance contract, the more closely the actual results/losses approach
the probable/predicted results that are expected from an infinite number of
exposures.

Section two

Insurable risk: meaning and characteristics

Section over view

80
The term risk stands for all factors which may endanger the operational activities of any
organization or and the life of individuals . More over to escape from the harmful consequences
that arise from the occurrence of risk, people buy insurance contracts. Hence this section deals
with the basic concepts of insurable risk and characteristics of insurable risks.

Objectives of this section

After completing this section , you will be able to

Elaborate the term insurable risk

Identify basic types of insurable risks

Characteristics of insurable risks.

Section outline

3.2.1 Insurable risk

3.2.2 Characteristics of insurable risks.

3.2.1 Insurable risk –meaning

Dear students !!! would you define the term insurable risk ?

Well!!! Insurable risks are basic categories of risks that an insurance company is wiling and
able to insure. Insurable risks are risks whose occurrence has the possibilities of loss or no loss.
Examples of insurable risk include death of an individual, loss of property or unintentional
damages made to other persons and other persons property.

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Among others the basic types of insurable risks that can be insured by insurance companies
can be divided in to three as follow

1. Property risks –are risks whose occurrence results in either total

damage or partial destruction of owned properties examples
include car accidents
2. Personal risks- are risks whose occurrence results in either
decreasing the value of human beings or death of an individual
examples include death of an individual, getting old age,
retirement, or getting poor health
3. Liability risks –are risks which include unintentional damages
made to other persons and other persons property.

Characteristics of insurable risks.

Dear students !!! would you define the basic requirements and characteristics of insurable
risks?

Well !!! Commercially insurable risks typically share seven common characteristics.

1. A large number of homogeneous exposure units. The vast majority of insurance policies
are provided for individual members of very large classes. The existence of a large
number of homogeneous exposure units allows insurers to benefit from the so-called
“law of large numbers,” which in effect states that as the number of exposure units
increases, proportionally the actual results are increasingly likely to become close to
expected proportions.
2. Definite Loss. The event that gives rise to the loss that is subject to the insured, at least
in principle, take place at a known time, in a known place, and from a known cause. The
classic example is death of an insured person on a life insurance policy. Fire, automobile
82
 accidents, and worker injuries may all easily meet this criterion. Other types of losses
may only be definite in theory. Occupational disease, for instance, may involve
prolonged exposure to injurious conditions where no specific time, place or cause is
identifiable. Ideally, the time, place and cause of a loss should be clear enough that a
reasonable person, with sufficient information, could objectively verify all three
elements.
3. Accidental or fortuitous loss.

A fortuitous loss is one of the most important factors considered by insurance companies
and refers to losses that happens accidentally, unexpectedly or the one that occur by
chance.

The event that constitutes the trigger of a claim should be fortuitous, or at least outside the
control of the beneficiary of the insurance. The loss should be ‘pure,’ in the sense that it
results from an event for which there is only the opportunity for cost. Events that contain
speculative elements, such as ordinary business risks, are generally not considered
insurable.

4. Large Loss. Insurance companies usually insure losses/accidents those losses which
would impair or jeopardize the life of an individual or seriously influence the
operational activities of the company. And to the contrary, minor and recurrent types of
looses may be disregarded or may not be considered by insures.

The size of the loss must be meaningful from the perspective of the insured. Insurance
premiums need to cover both the expected cost of losses, plus the cost of issuing and
administering the policy, adjusting losses, and supplying the capital needed to reasonably
assure that the insurer will be able to pay claims.

For small losses these latter costs may be several times the size of the expected cost of
losses. There is little point in paying such costs unless the protection offered has real value
to a buyer.

83
5. Economically affordable and feasible Premium. Here, the premium charged by the
insurance company should be economical and affordable to the insured and moreover,
for the sake of making the purchase of insurance contract more attractive, the premium
to be charged must be substantially less the face value or the of policy. And also in order
to have an economically feasible premium, the chance of loss must be relatively low.

If the likelihood of an insured event is so high, or the cost of the event so large, that the
resulting premium is large relative to the amount of protection offered, it is not likely that
anyone will buy insurance, even if on offer. Further, as the accounting profession formally
recognizes in financial accounting standards, the premium cannot be so large that there is
not a reasonable chance of a significant loss to the insurer. If there is no such chance of loss,
the transaction may have the form of insurance, but not the substance.

6. Calculable Loss. There are two elements that must be at least estimable, if not formally
calculable: the probability of loss, and the attendant cost. Probability of loss is generally
an empirical exercise, while cost has more to do with the ability of a reasonable person
in possession of a copy of the insurance policy and a proof of loss associated with a
claim presented under that policy to make a reasonably definite and objective
evaluation of the amount of the loss recoverable as a result of the claim.
7. The loss must not be catastrophic

This means that large number of exposure units should not get or incur losses at the same
time. It means most or all of the exposure units under a given insurance contract shouldn’t
get loss, other wise the basic ideas and aims of polling in not going to be
dependable/realistic, basically insurance companies need to avoid catastrophic risks ,but in
real world, this is impossible since catastrophic losses result from some perils which are too
difficult to predict or controlled by human beings such as flood, earthquake, volcanoes ,etc

84
 Generally the two approaches that are available for meeting problems of catastrophic
losses include:

i. Reinsurance can be used by which the insurance companies are indemnified by the
re-insurers for the catastrophic losses.
ii. Insurance companies can avoid the concentration of risks by dispersing their
coverage over a large geographical area if the loss exposures are geographically
dispersed then possibility of catastrophic loss is reduced .

The essential risk is often aggregation. If the same event can cause losses to numerous
policyholders of the same insurer, the ability of that insurer to issue policies becomes
constrained, not by factors surrounding the individual characteristics of a given
policyholder, but by the factors surrounding the sum of all policyholders so exposed.
Typically, insurers prefer to limit their exposure to a loss from a single event to some small
portion of their capital base, on the order of 5 percent. Where the loss can be aggregated,
or an individual policy could produce exceptionally large claims, the capital constraint will
restrict an insurer's appetite for additional policyholders. The classic example is earthquake
insurance, where the ability of an underwriter to issue a new policy depends on the number
and size of the policies that it has already underwritten. Wind insurance in hurricane zones,
particularly along coast lines, is another example of this phenomenon. In extreme cases, the
aggregation can affect the entire industry, since the combined capital of insurers and
reinsurers can be small compared to the needs of potential policyholders in areas exposed
to aggregation risk. In commercial fire insurance it is possible to find single properties
whose total exposed value is well in excess of any individual insurer’s capital constraint.
Such properties are generally shared among several insurers, or are insured by a single
insurer who syndicates the risk into the reinsurance market.

Summary

85
 Insurance is a process of predicting, pooling, spreading and then sharing equally accidental
risks faced by few unfortunate individual among the entire group of insureds who belong to the
same insurance category and also who posses similar/related exposures.

The basic characteristics of insurance contract consists of contracts of adhesion, aleatory

contracts ,risk transfer, indemnification, contracts of utmost good faith, Pooling of losses,
unilateral contracts and payment of fortuitous losses. Insurable risks are those risks that an
insurance company is willing to accepts and able to compensate .

Review questions

1. Define the term insurance contract from insureds, insurance

companies, legal, societies, and business points of view?
2. Discuss on the most important characteristics of insurance contracts?
3. What is meant by insurable risk?
4. What categories’ of risks , do you think that , get guarantee under insurance
contracts?
5. What are the most important characteristics of insurable risks?
References
Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company ,USA
Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc Graw Hill
company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002 Jhon
Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw Hill
company ,USA
86
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA

Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA

Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA

Skipper, Harold and W. Jee ,Risk Management and Insurance: Perspectives in a Global
Economy,2007, Black well Publishing,Australia

Unit Four

Legal principles of insurance contracts

Learning objectives

At the end of this unit, you will be able to:

Understand parties who take part in the insurance contract

Recognize the basic legal principles that underlie all insurance contracts

Unit introduction

Insurance contract is effected by legal agreements known as policies or contracts. A contract

,contrary to the impression of many, cannot be complete in itself, but must be interpreted in
the light of the legal and social environment of the society in which it is made.

The principles outlined in this introductory unit form the elements of insurance that everyone
in the insurance business and contract must understand.

And some of the most important factors to be considered by parties who engage in the
insurance contracts are as follow ;

87
.Transferring and spreading risk

In routine operation, a company may be exposed to the risks of many kinds.

Some perils (events that can cause damage or loss) are foreseeable, or even predictable.
Insurance can do nothing to help the company in such cases. The risk must be accepted, or the
business must be declined.

Other events are unpredictable, or fortuitous. Everyone understands that “accidents will
happen”, but (by definition) nobody knows when an accident will happen, or even if it will
happen. Insurance can help the company in case of fortuitous events (also known as
“fortuities”).

Insurance provides protection by compensating financial loss that arises from fortuities. The
loss must be measurable in monetary value. The insurer charges the insured party a premium in
proportion to the degree of risk and the monetary value of the potential loss.

Insurance is a risk transfer mechanism. The insurer deals with thousands of insured parties and
can thus spread the risks he has acquired by placing funds built up from thousands of premiums
into a pool. Since it is unlikely that all insured parties will incur financial loss at the same time
(or at all), the insurer will be able to draw money from the pool to compensate insured parties

Insurable risks

Not all risks are insurable:

You cannot insure against speculative risks and these are risks which have the chance of
loss or no loss. Example a policy/contract on gambling would be prohibited by law.

Insurance held against the public interest will be invalid. For example, speeding fines
incurred by truck drivers are an uninsurable risk.

88
 In situations of war, cargoes cannot be covered against land risks. Risks to ships or
aircraft and their cargoes can, however, be covered.

Unit outline

The specific and main legal doctrines/principles that underline the insurance contract are the
following:

4.1 Insurable interest

4.2 Utmost good faith

4.3 Proximate cause

4.4 Indemnity

4.5 Subrogation

4.6 Contribution

4.1 The principles of “Insurable interest”

Dear students!!! What do you know about principles of insurable interest?

 Insurable interest distinguishes contracts of insurance from gambling in order to define

the legitimate area of insurance business.
 Insurable interest is required for all types of insurance and its absence renders the
contract void and hence unenforceable.
 Insurable interest can be acquired in various ways notably:
(1) Ownership
(2) Legal possession

89
 (3) Custody of property belonging to others
(4) Marriage-spouses have an insurable interest in each other’s life.
(5) A lien-holder has insurable interest in the property subject to the lien.
(6) A debt creates insurable interest between debtor and creditor.
(7) An employer has an insurable interest in the life of an employee.
 In life insurance the general rule is that insurable interest need only exist at the time of
taking the policy. Thus if A who is married to B takes a life policy on his life and they
later divorce the policy will pay on B’s death even if technically insurable interest no
longer exists because the parties divorced.

The essentials of insurable interest are as follow:

“Insurable interest” is the legal right to insure. Without it, an insurance policy is invalid.

The basic criteria for insurable interest must be met:

1. The presence of subject matter to be insured .

It means that there must be something capable of being insured – i.e. property, a right, a
commercial interest, a life or a limb, or some potential liability.

2. This property (etc) must be the “subject matter” of the insurance/i.e policy holder.

3. The insured party /i.e. policy holder must have a certain financial relationship to the
“subject matter”.

. 4. The insured party/i.e. policy holder must have legal relationship to the “subject matter
that means the relationship must be legally recognized.

The insured party i.e. the policy holder must benefit from the safety of the subject matter (or
from freedom from liabilities).

90
 The insured party i.e the policy holder must be prejudiced by the subject matter’s loss,
damage, delay, injury or creation of liability.

If any of these relationship criteria is unmet, the risk can not be insured. You cannot,
therefore, insure someone else’s vessel against sinking, nominating yourself to receive
compensation.

4.2 The principles of “Utmost good faith”

Dear students!!! What do you know about principles of utmost good faith?

Well !!! The insured party usually knows all about:

-- the risk he intends to insure, and

-- his/ her own past insurance history.

This gives the insured party an advantage over the insurer in making a contract of insurance.
The law therefore requires anyone seeking insurance to disclose all “material facts” to the
insurer before he takes on the risk. Claims must also be presented in good faith: an exaggerated
claim could amount to a fraudulent claim.

When you give insurers information about a risk you want them to underwrite, you must be fair
and truthful in your discussions and must not misrepresent any detail. You, as the insured
party, are responsible for disclosing information about your business, its insurance history and
its experience. The insurer should not need to elicit information by asking for it – and the fact
that an insurer does not ask about a “material fact” does not discharge you from your duty to
disclose the information voluntarily.

91
The consequences of misrepresentation and non-disclosure are severe. The policy can be
declared void from the date it began (“ab initio”), so that both

- the claim that gives notice of a breach of utmost good faith can be declined

- any other claim made under the policy can also be declined.

No connection between a declined claim and a misrepresented or undisclosed material fact is

required. So even if your loss is unrelated in any way to the misrepresentation or non-
disclosure the same consequences can prevail. Thus, a proven non-disclosure is likely to leave
you uninsured, having to meet your losses from your own funds.

Good faith and “material facts”

Material facts, that are known – or ought reasonably to be known – to the insured party, must
be disclosed to the potential insurer. It is no defense for you to say that you did not realize that
a fact was material. It is also important to remember that an innocent misrepresentation has
the same effect as a fraudulent one

Even if full and accurate disclosure would not, in itself, have decisively affected the insurer’s
judgment about acceptance and premium, something that you misrepresent or fail to disclose
may still be proved material.

- Once materiality is proved, the burden of establishing that the misrepresentation or non-
disclosure did not induce the making of the contract lies with the insured party.

- If the misrepresentation or non-disclosure of a material fact did actually induce the

making of the contract, the insurer is entitled to render the policy void. However, the the court
may require the insurer to demonstrate that this was so.

Unless the policy provides otherwise, the duty of disclosure continues up to the time at which
the contract is made. The duty then ends, although any later changes that could take the risk
outside the scope of the policy must still be disclosed. However, a specific term in your policy

92
may impose on you a continuing duty to disclose, i.e. you must tell the insurer about any
material change in your business during the term of the policy. (Ask your broker or insurer if
you are unsure.)

The duty to disclose all material facts will arise again when the policy is due for renewal.

Examples of facts that must be disclosed

No list of examples can be exhaustive, but facts that are material (and should therefore be
disclosed) include the following:

- the fact that goods are of high value

- the fact that goods are fragile

- the fact that goods are second hand

- information about geographical trading areas

- information about storage periods

- information about storage premises

- the fact that another insurer has refused to renew a policy of the type being negotiated

- your previous claims experience.

It is your duty to provide all material information, so you should make sure you disclose every
fact that could be material (even if you are not sure about it) so that the insurer can decide
whether it is material.

Facts that need not be disclosed

Some facts need not be disclosed:

93
- facts that reduce the risk

- facts of law

- facts within the insurer’s own domain

- facts that the insurer would be expected to know from general knowledge of the world at
large and from the class of insurance concerned.

The last point means that an insurer should not decline a claim because “he was unaware that a
tilt trailer had soft sides” that thieves could easily breach. When an insurer underwrites marine
cargo or freight-related business, it is reasonable to expect that he knows the characteristics of
a transport unit. Any such ignorance on his part would be inconsistent with the principle of
utmost good faith. On the other hand, if you used the trailer as a storage unit (i.e. not in the
normal course of transit), this could breach the principle on your side.

4.3 The principles of “Proximate cause”

Dear students!!! What do you know about principles of proximate cause?

“Proximate cause” is a legal term that refers to exactly how a loss occurred. The cause of a loss
must be established because only risks specifically insured against can be compensated. If there
is more than one cause for a loss, the dominant and effective cause is the one considered; a
more remote cause will not count.

4.4 The principles of “Indemnity”

Dear students!!! What do you know about principles of indemnity?

94
  The principles of “Indemnity” is perhaps the most fundamental principle of insurance
law. Object of indemnity is to place the insured after the loss in the same position he
occupied immediately before the loss. He is not to be placed in a better or worse position.
 Not all insurance contracts are contracts of indemnity e.g. life insurance. Indemnity is
important as it deals in part with moral hazard.
 Indemnity does not imply that the insured will be indemnified to the full value of his loss
e.g. a person whose factory is destroyed by fire cannot recover for loss of profits or
against any liability that may arise from the fire unless he has appropriate policies in place
specifically designed to deal with these losses.
 Indemnity can be achieved through the following methods:
1. Cash
2. Reinstatement e.g. where a building is destroyed, insurers may reinstate it.
3. Repair e.g. where a motor vehicle is partially damaged.
4. Replacement-instead of paying cash a replacement item may be tendered.
5. New for old-used for household contents. This is not a violation of the principle
of indemnity as there is no principle of law that requires indemnity to be
determined in terms of the market value of the asset.
6. Valued policies-in terms of which the insurer and the insured agree before hand on
the value to be paid should a particular asset be destroyed or stolen. This method of
indemnity is used for assets with a sentimental rather than a commercial value e.g.
jewellery, works of art etc.
 The principle of indemnity is supported by 2 corollaries namely-subrogation and
contribution.

The object of an insurance policy is to restore an insured party to the financial position he had
before a loss occurred. This principle allows insurers to make deductions from a claim to reflect
fair wear and tear, and it also normally ignores any loss of profit. However, it is possible to build

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into a policy an indemnity that determines the compensation payable (subject to any exclusions
in the policy). For a liability policy, indemnity should match the extent of your legal liability, as
determined by law. The rules of indemnity prevent an insured party from claiming more than
the true amount of his loss.

4.5 The principles of “Subrogation”

Dear students!!! What do you know about principles of indemnity?

 Literally subrogation” means “to stand in place of”. It is the right of one person to stand
at law in the place of another and to avail him of all rights and remedies of that other
person.
 Often when a claim occurs there may be 2 avenues of recovery. Suppose A drives
negligently and causes an accident damaging B’s car. If B’s car is insured 2 options are
open to him to recover his loss-he can sue A for the occurrence of accident.
 for damages or he can claim from his insurer. If B pursues both avenues he will receive
double compensation.
 To prevent B from profiting from his loss subrogation is used in terms of which once the
insurer has paid B the insurer assumes all B’s rights to sue A. This ensures that the
principle of indemnity is preserved.
 Subrogation has a number of sub-principles namely:

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  The insurer cannot be subrogated to the insured’s right of action until it has paid the
insured and made good the loss.
 The insurer can be subrogated only to actions which the insured would have brought
himself.
 The insurer must not prejudice the insurer’s right of subrogation. Thus the insured may
not compromise or renounce any right of action he has against the 3rd party if by doing
so he could diminish his loss.
 Subrogation against the insurer. Just as insured cannot profit from his loss the insurer
may not make a profit from the subrogation rights. The insurer is only entitled to
recover the exact amount they paid as indemnity nothing more. If they recover more
the balance should be given to the insured.
 Subrogation gives the insurer the right of salvage.

Once an insurer has paid a claim, he becomes entitled to take over all your legal rights to
pursue the claim against any third party, sub-contractor, etc, who may be responsible for the
loss, damage or liability.

4.6. The principles of “Contribution”

Dear students!!! What do you know about principles of Contribution

The principles of “contribution” is another principle that aids indemnity. Often a

person has more than one policy on the same asset. Following a loss the position
of the 2 policies is governed by the principle of contribution. Since indemnity
forbids the insured from recovering more than the loss then he cannot recover
the full value of the loss from each of the 2 policies.

 The law does not forbid people from engaging in double insurance it only forbids profiting
from a loss.

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  Under the common law a person who has double insurance can look to any of the insurers
involved for compensation. The insurer who would have paid can then claim contribution
from the other insurer involved.
 Essentially for contribution to apply the following conditions must be met:
(1) The 2 policies must cover the same insured.
(2) They must cover the same subject matter.
(3) They must cover the same interest.
(4) The peril causing the loss must be covered by both policies
albeit for different amounts.
(5) Both policies must be current.
 Normally the policies contribute pro-rata to the loss. In some markets the independent
liability method is used to determine the levels of contribution. Under this method if the
loss is within the sums insured of both policies they contribute equally to the loss.

The rules of indemnity prevent an insured party from claiming more than the true amount of
his loss. If he has more than one policy covering the same risk against the same peril, he is
therefore unable to claim his full loss against each policy. However, if the insured party decides
to claim the full amount from one insurer, each insurer is entitled to call for a contribution from
every other insurer involved.

Summary

the legal principles of insurance contracts are basic principles that must be precisely known
among parties who enter in to the insurance contracts and these contracts are used to make
the agreement or contract to be made between the insured and insurer effective and valid
.among others, these principles include principles of Insurable interest, utmost good faith,
proximate cause ,indemnity, subrogation, and contribution

Review questions

1. What is meant by legal principles of insurance contracts?

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2. Do you think that legal principles of insurance contracts have
international or local applications? why?
3. Specify why legal principles of insurance contracts are always
mandatory rather than optional and hence needed or considered before or while effecting
an insurance contracts?
4. What are the most important categories of legal principles of insurance contracts?
5. Describe also the most important concepts and features of each legal principles of
insurance contracts and under what situations they will be used?
6. Under the principles of indemnity, why it is determined that the amount of compensation
to be paid must commensurate the actual loss faced?
7. Discuss on whether the role of insurance services is either profiting or restoring insured’s to
their former economic position
8. Under the principles of subrogation, do you think that the insured can sue and collect
compensation from the wrong doer(the culprit) -third party? why and why not?
9. What are the most important factors that violate the principles of utmost Good Faith?
10. In your opinion, how many i.e. minimum number of insurance companies must exist so as
to apply the principles of contribution?
11. Under the principles of contribution or subrogation, do you think that ai insured can collect
compensation more than the actual loss she/he has faced?
12. Mention why it is suggested that the principles of contribution or subrogation are
segments of the principles of indemnity?

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 References

Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company ,USA
Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc Graw Hill
company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002 Jhon
Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw Hill
company ,USA
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA

Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA

Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA

Skipper, Harold and W. Jee ,Risk Management and Insurance: Perspectives in a Global
Economy,2007, Black well Publishing,Australia
Trieschmann, Hoyt and sommer,Risk Management,12 th ed. 2005, South Western ,USA

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 Unit Five

Property insurance contracts

Learning objectives

At the end of this unit, you will be able to:

Understand the term property risk

Elaborate the term property insurance contract

Explain the different types of property insurance contracts

Unit introduction

Any risk that can be quantified can potentially be insured. Specific kinds of risk that may give
rise to claims are known as "perils". An insurance policy will set out in detail which perils are
covered by the contract and which are not. Below are (non-exhaustive) lists of the many
different types of property insurance contracts that exist. A single contract may cover risks in
one or more of the categories set out below. For example, auto insurance would typically cover
both property risk (covering the risk of theft or damage to the car) and liability risk (covering
legal claims from causing an accident). A homeowner's insurance policy in the Ethiopia typically
includes property insurance covering damage to the home and the owner's belongings, liability
insurance covering certain legal claims against the owner, and even a small amount of coverage
for medical expenses of guests who are injured on the owner's property.

In general ,property insurance contracts

. Offer/give indemnity for property risks
. Property risks are risks which may decrease/damage/ or destroy the values of owned
properties

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.Are insurance contracts which are designed to give compensation for the loss of, damages or
destruction of owned properties (i.e some fixed assets like cars, automobiles, houses, ship,
etc…)
. Are insurance contracts made between the insured and the insurer in which case
i. The insured pays premium for and then transfers property risks to an insurance
company
ii. The insurer accepts premium and then promises to pay compensation for the
occurrence property risks faced by the insured.

Unit outline

Property insurance contracts provides protection against loss of ,damages or destruction

of owned properties. Though there are quite tremendous types of property insurance
contracts, the following are some

5.1 Automobile insurance contracts

5.2 Aviation insurance contracts
5.3 Marine insurance contracts
5.4 Fire insurance contracts
5.5 Fidelity guarantee insurance contracts
5.6 Theft insurance contracts

5.1 Automobile insurance contracts

Dear students !!! what do know about Automobile insurance contracts?

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 Automobile insurance, known in the Ethiopia as motor insurance, is probably the most
common form of insurance contracts and may cover both legal liability claims against
the driver or to the owner and loss of or damage or destruction to the insured's vehicle
itself. Throughout Ethiopia, 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.

Two types of automobile insurance policies/ i.e. contracts are issued by Ethiopian
insurance companies in Ethiopia

i. private vehicle policy

ii. commercial vehicles policy

i. private vehicles policy

Motor vehicles covered by this policy are those that are exclusively used for
private purposes: social, domestic, pleasure or professionals. They are used
for hiring, facing, pace making; speed testing and the like are excluded from
this policy. This policy then indemnifies the insured against loss of damage to
motor vehicles resulting from any accidental collusion or overturning due to
mechanical break down, wear and tear, fire, external explosion, self ignition,
burglary, housebreaking, theft or damage caused by malicious act. The policy
also gives cover against damages that could happen while the vehicles is in
transit road, rail, waterways, or lift-including losses that arising from the
process of loading and unloading during transit activities.

ii. Commercial vehicle policy

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 Are designed to give the same protection as with that of the private vehicle
policy except that the vehicles insured under this policy are those that are
used for commercial purposes. A wide range of vehicles used for transporting
goods and passengers are covered by this policy. The motor vehicles under
this policy are classified as follows:

Goods carrying vehicles

Tankers,buses, axis, car-hire ,motor cycles

Special types of vehicles –such as earth moving equipments, ambulances,

agricultural vehicles, dumpers, fire brigade vehicles, etc.

Automobile insurance contracts provides two types of insurance cover

i. Comprehensive cover-which indemnifies the insured for the loss or damages suffered by
owned vehicles

[Link] party liability cover- which gives cover against third part liability death or bodily injury to
third parties or damages caused to their property.

5.2 Fire insurance contracts

Dear students !!! what do know about fire insurance contracts?

Fire insurance contract means the business of effecting, otherwise than incidentally to some
other class of insurance business, contracts of insurance against loss by or incidental to fire or
other occurrence, customarily included among the risks insured against in fire insurance
business.

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According to Halsbury, it is a contract of insurance by which the insurer agrees for
consideration to indemnify the assured up to a certain extent and subject to certain terms and
conditions against loss or damage by fire, which may happen to the property of the assured
during a specific period.

Insurable property includes: premises, stock and material in the business and belonging to the
insured in trust or commission for which the insured is responsible, fixtures, fittings, machinery
etc.

Thus, fire insurance is a contract whereby the person seeking insurance protection enters into a
contract with the insurer to indemnify him against loss of property by or incidental to fire or
lightning, explosion etc.

Exclusions under fire insurance contracts

The condition of this policy states that the insurer will not be liable for any mis interpretation,
omission, or misdescription of the insured property .The policy is not issued on along term
basis.

The policy/contract doesn’t cover;

Loss by theft during or after the occurrence of fire

Loss or damage to property arising out of climatic conditions inherent in chemical reactions, etc

Burning of the property by the order of a government officials or subterranean fire

5.3 Aviation insurance contracts

Dear students !!! what do know about Aviation insurance contracts?

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Aviation insurance contract is an insurance contract that provides a protection against

i. Loss or damage to the air craft—where protection is provided for the loss or damages to the
air craft by any outcome except those specifically excluded in the policy

ii. Third party legal liabilities

Liability can be divided basically into two categories:

1. Liability in respect of Passengers, Baggage, Cargo and Mail carried on the aircraft. These
liabilities result from the operations the airline is set up to perform and are normally the
subject of a contract of carriage like a ticket or airway bill, which provides some
possibility of limiting the airline's liability.
2. Aircraft Third Party Liability - the liability for damage done to property or people outside
the aircraft itself.

Every airline will arrange liability insurance for these two categories, normally in a single liability
policy. In many countries there are requirements laid down imposing minimum limits of liability
that are a prerequisite to obtaining an operator's license. Elsewhere limits are specified for an
aircraft to be allowed to land. The size of limit required is often related to the size of the aircraft
concerned (and its potential for causing damage). A small aircraft operating only in remote
regions and using small airstrips incurs considerably less potential exposure than an aircraft
flying into and out of major airports.

Exclusions under aviation insurance contracts

The condition of this policy states that the insurance company will not be liable for the losses
that arise out of the following conditions

1. Damage to the Insured's own property. (It is after all a third party liability policy).

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 2. War and Allied Risks although these are "written back" by a device called "The Extended
Coverage Endorsement .
3. Radioactive Contamination.
4. Noise and Pollution - unless caused by or resulting in a crash, fire, explosion or recorded
"in flight" emergency
5. Wear, tear and gradual deterioration - in common with most non-marine policies these
perils are thought to be a trading expense and not a peril to be insured.
6. Ingestion damage - caused by stones, grit, dust, sand, ice, etc., which result in
progressive engine deterioration is also regarded as "wear and tear and gradual
deterioration", and as such is excluded. Ingestion damage caused by a single recorded
incident (such as ingestion of a flock of birds) where the engine or engines concerned
have to shut down is not regarded as wear and tear and is covered subject to the
applicable policy deductible.
7. Mechanical Breakdown - likewise is thought by aviation insurers to be an operating
expense, but subsequent damage outside the unit concerned is usually covered.
However, it is possible to obtain insurance coverage against mechanical breakdown of
engines by way of a separate policy. This coverage has a high degree of exposure and as
a result is relatively expensive. The majority of airlines do not purchase it probably
viewing such exposure as a part of the "engineering" budget.

5.5 Fidelity guarantee insurance contracts

Dear students !!! what do know about fidelity guarantee insurance contracts?

Fidelity Guarantee policy will indemnify employers against direct loss of money or other
property resulting from acts of fraud or dishonesty committed by their employees.

The schedule includes:

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The name of the employer

Position of the employee

Date of commencement of the risk and the amount guaranteed in connection with each
employee

Exclusions under fidelity guarantee insurance contracts -

The Policy does not cover: -
(a)Losses discovered more than 18 months after the expiry of the Policy or the termination of
the service of the employee concerned,
(b) Defaults of an employee occurring after previous acts of dishonesty by the same employee
have been discovered or suspected,
(c) Losses occurring after there has been a change in the system of Supervision and check
exercised over the employees and their accounts which has not received the Company's prior
approval,
(d) Cash or stock shortages not caused by fraud or dishonesty or trading losses, which cannot
be accounted for.

Pre-requisites of fidelity guarantee insurance contracts

Insurance companies , in many cases, before(pre-requisites) selling such contracts to banks,

usually reconsider the following most important points/factors
. method of employee recruitment, selection, and performances appraisals
.methods of the bank’s current management styles and supervision
. methods of compensating organizational workers
.performance appraisal records of (past, current, and future)accountants and auditors
. past, current and future performance of accountants and auditors
. past and current criminal records of accountants and auditors
. accountants and auditors level of education, hoppies, merit, service period, skill, marital
status, loyalty, commitment, absenteeism, turnover rates,social relationships ,etc,….

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 5.6 Marine insurance contracts

Dear students !!! what do know about Marine insurance contracts?

Marine Insurance contracts covers the loss or damage of ships, cargo, terminals, and any
transport or property by which cargo is transferred, acquired, or held between the points of
origin and final destination.

Cargo insurance—discussed here—is a sub-branch of marine insurance, though Marine also

includes Onshore and Offshore exposed property (container terminals, ports, oil platforms,
pipelines); Hull; Marine Casualty; and Marine Liability.

Within the overall guidance of the Marine Insurance Act and the Institute Clauses parties retain
a considerable freedom to contract between themselves.

5.7 Theft insurance contracts

Dear students !!! what do know about theft insurance contracts?

Theft insurance contracts are contracts which are designed to give compensation for the loss of
owned properties through burglary and robbery acts committed by some one other than
organizational workers.

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Coverage Description

What should I insure?

The Theft Insurance Program applies to property that is attractive to thieves. Examples of
property for which the theft insurance is intended include:

 Computer equipment (personal computers, laptops, printers, monitors, scanners,

modems and other hardware)
 Office equipment (fax machines, desktop copy machines, typewriters, telephone
answering machines and calculators)
 Electronic equipment (video projectors, televisions, video cameras, video recorders,
radios and stereos)
 Laboratory equipment (microscopes and balances)
 Communications equipment (mobile phones and walkie-talkies)
 Other equipment that is prone to loss by theft (musical instruments, cameras, etc.)
 Portable property insured under this program is covered for accidental damage while in
transit or away from campus with unit approval.

Exclusions under theft insurance contracts

The Theft Insurance Program does NOT apply to:

 Personal property owned by faculty, staff, students, or others

 Computer software and data
 Money, securities, stamps and similar property
 Property away from an insured organization facilities unless approved in advance by the
unit to which the property is assigned.

5.8 Home owners insurance contracts

Dear students !!! what do know about home owners insurance contracts?

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Home insurance provides compensation for damage or destruction of a home from disasters. In
some geographical areas, the standard insurances exclude certain types of disasters, such as
flood and earthquakes, that require additional coverage. Maintenance-related problems are
the homeowners' responsibility. The policy may include inventory, or this can be bought as a
separate policy, especially for people who rent housing. In some countries, insurers offer a
package which may include liability and legal responsibility for injuries and property damage
caused by members of the household, including pets.

Summary

Property insurance contracts provides protection against loss of ,damages or

destruction of owned properties. Though there are quite tremendous types of property
insurance contracts, the following are some automobile insurance contracts, aviation insurance
contracts, marine insurance contracts, fire insurance contracts, fidelity guarantee insurance
contracts, and theft insurance contracts

Review questions

1. What is meant by property risk(s)?

2. Discuss what is meant by property insurance contract?
3. What types of risks and exposures are expected to be insured
under property insurance contracts?
5. Mention the different types of property insurance contracts?
6. Specify also basic exposures to be insured under the different types of property insurance
contracts?

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7. Mention also exclusions i.e -excluded risks-which do not guarantee under the different
types of property insurance contracts?

References
Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company ,USA
Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc Graw Hill
company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002 Jhon
Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw Hill
company ,USA
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA

Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA

Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA

Skipper, Harold and W. Jee ,Risk Management and Insurance: Perspectives in a Global
Economy,2007, Black well Publishing,Australia
Trieschmann, Hoyt and sommer,Risk Management,12 th ed. 2005, South Western ,USA

Unit Six

Liability insurance contracts

Learning objectives

At the end of this unit, you will be able to:

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Understand the term liability risk

Elaborate the term liability insurance contract

Explain the different types of property insurance contracts

Unit introduction

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.

Liability insurance is a part of the general insurance system of risk financing to protect the
purchaser (the "insured") from the risks of liabilities imposed by lawsuits and similar claims. It
protects the insured in the event he is sued on types of claims that come within the policy.
Originally, individuals or companies that faced a common peril, formed a group and created a
self-help fund out of which to pay compensation should any member incur loss. The modern
system relies on dedicated carriers to offer protection against specified perils in consideration
of a premium. Liability insurance is designed to offer specific protection against third party
claims, i.e., payment is not typically made to the insured, but rather to someone suffering loss
who is not a party to the insurance contract. In general, damage caused intentionally and
contractual liability are not covered under liability insurance policies. When a claim is made, the
insurance carrier has the right to defend the insured. The legal costs of a defense are not

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always affected by any policy limits, which is useful because they can be significant where long
trials are held to determine either fault or the amount of damages.

In many countries, liability insurance is a compulsory form of insurance for those at risk
of being sued by third parties for negligence. The most usual classes of mandatory policy cover
the drivers of vehicles, those who offer professional services to the public, those who
manufacture products that may be harmful, constructors and those who offer employment.
The reason for such laws is that the classes of insured are deliberately engaging in activities that
put others at risk of injury or loss.

In general, liability insurance contracts

.offer indemnity for liability risks

. liability risks are risks are risks/damages/ losses made to other or other persons property
. are insurance contracts which offer/give indemnity for risks/damages/ losses made to other or
other persons property.

Section outline

6.1 Public liability insurance contracts

6.2 Product liability insurance contracts

6.3 Employers liability insurance contracts

6.4 Professional liability insurance

6.1 Public liability insurance contracts

Dear students !!! Would you discuss about public liability insurance contracts ?

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Industry and commerce are based on a range of processes and activities that have the potential
to affect third parties (members of the public, visitors, trespassers, sub-contractors, etc. who
may be physically injured or whose property may be damaged or both). It varies from state to
state as to whether either or both employer's liability insurance and public liability insurance
have been made compulsory by law. Regardless of compulsion, however, most organizations
include public liability insurance in their insurance portfolio even though the conditions,
exclusions, and warranties included within the standard policies can be a burden. A company
owning an industrial facility, for instance, may buy pollution insurance to cover lawsuits
resulting from environmental accidents.

Many small businesses do not secure general or professional liability insurance due to the high
cost of premiums. However, in the event of a claim, out-of-pocket costs for a legal defense or
settlement can far exceed premium costs In some cases, the costs of a claim could be enough
to shut down a small business.

Businesses must consider all potential risk exposures when deciding whether liability insurance
is needed, and, if so, how much coverage is appropriate and cost-effective. Those with the
greatest public liability risk exposure are occupiers of premises where large numbers of third
parties frequent at leisure including shopping centers, pubs, clubs, theaters, sporting venues,
markets, hotels and resorts. The risk increases dramatically when consumption of alcohol and
sporting events are included. Certain industries such as security and cleaning are considered
high risk by underwriters. In some cases underwriters even refuse to insure the liability of these
industries or choose to apply a large deductible in order to minimize the potential
compensations. Private individuals also occupy land and engage in potentially dangerous
activities. For example, a rotten branch may fall from an old tree and injure a pedestrian, and
many ride bicycles and skateboards in public places. The majority of states requires motorists to
carry insurance and criminalize those who drive without a valid policy. Many also require
insurance companies to provide a default fund to offer compensation to those physically
injured in accidents where the driver did not have a valid policy.

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In many countries claims are dealt with under common law principles established through a
long history of case law and, if litigated, are made by way of civil actions in the relevant
jurisdiction.

In general public liability insurance contracts covers a business against claims should its
operations injure a member of the public or damage their property in some way.

6.2 Product liability insurance contracts

Dear students !!! Would you discuss about product liability insurance contracts ?

Product liability insurance is not a compulsory class of insurance in all countries, but legislation
such as the Ethiopia . Consumer Protection Act 1987 and the EC Directive on Product Liability
(25/7/85) require those manufacturing or supplying goods to carry some form of product
liability insurance, usually as part of a combined liability policy. The scale of potential liability is
illustrated by cases such as those involving Mercedes-Benz for unstable vehicles and Perrier for
benzene contamination, but the full list covers pharmaceuticals and medical devices, asbestos,
tobacco, recreational equipment, mechanical and electrical products, chemicals and pesticides,
agricultural products and equipment, food contamination, and all other major product classes.

6.3 Employers liability insurance contracts

Dear students !!! Would you discuss about employers liability insurance contracts ?

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New policies have been developed to cover any liability that might be imposed on an employer
if an employee is injured in the course of his or her employment. In many states, the insurers
are prohibited from including conditions within their policies that seek to impose any
unreasonable conditions precedent to liability, or require the insured either to take reasonable
precautions or to comply with current legislation and regulations. In those countries where
such insurance is not compulsory, smaller organizations are often driven into bankruptcy when
faced by claims not covered by insurance.

Many of the public and product liability risks are often covered together under a general
liability policy. These risks may include bodily injury or property damage caused by direct or
indirect actions of the insured.

6.4 Professionals liability insurance contracts

Dear students !!! Would you discuss about professionals liability insurance contracts ?

Professional liability insurance, also called professional indemnity insurance, protects

insured professionals such as architectural corporation and medical practice 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 malpractice
insurance.

Summary

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Liability insurance contracts are insurance contracts which offer/give indemnity for
risks/damages/ losses made to other or other persons property.

Among others liability insurance contracts include public liability insurance contracts, product
liability insurance contracts, employers liability insurance contracts, and professional liability
insurance

Review questions

1. What is meant by liability risk(s)?

2. Differentiate the term liability risk from property
risks?
3. Describe the basic concepts and characteristics of liability
insurance contracts?
4. What types of risks and exposures are expected to be insured under
liability insurance contracts?
5. Mention the different types of liability insurance contracts?
6. Specify also basic exposures to be insured under the different types
of liability insurance contracts?
7. Mention also exclusions i.e. -excluded risks-which don’t guarantee
under the different types of liability insurance contracts?
References
Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company ,USA
Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc Graw Hill
company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002 Jhon
Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw Hill
company ,USA

118
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA

Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA

Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA

Unit seven

Life insurance contracts

Learning objectives

At the end of this unit, you will be able to:

Elaborate the term life insurance contract
Understand the basic features of life insurance contracts
Recognize the different types of life insurance contracts

Section one
Definitions and characteristics of life insurance contracts
Section over view

Life insurance provides a monetary benefit to a decedent's family or other designated

beneficiary, and may specifically provide for income to an insured person's family, burial,
funeral and other final expenses. Life insurance policies often allow the option of having the
proceeds paid to the beneficiary either in a lump sum cash payment or an annuity.

Annuities provide a stream of payments and are generally classified as insurance because they
are issued by insurance companies and regulated as insurance and require the same kinds of
actuarial and investment management expertise that life insurance requires. Annuities and
pensions that pay a benefit for life are sometimes regarded as insurance against the possibility

119
that a retiree will outlive his or her financial resources. In that sense, they are the complement
of life insurance and, from an underwriting perspective, are the mirror image of life insurance.

Certain life insurance contracts accumulate cash values, which may be taken by the insured if
the policy is surrendered or which may be borrowed against. Some policies, such as annuities
and endowment policies, are financial instruments to accumulate or liquidate wealth when it is
needed. Besides ,life insurance contracts are long term insurance contracts between the
insured and the insurer and may have some more unique characteristics as discussed below.

Section objectives

After completing this section, you would be able to :

Elaborate the term life insurance contract

Understand the basic features of life insurance contracts

Section outline

1. Life insurance contracts

2. Features of life insurance contacts

7.1.1 Life insurance contracts

Dear students!!! What do you know about life insurance contracts?

Are insurance contracts

which offer indemnity for losses arising out of death of an individual

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 o Are insurance contracts which give compensation for the worst type of risk
that all people in this planet face i.e. DEATH – i.e. the most ugly word in the
dictionary.

Life insurance or life assurance is a contract between the policy owner and the insurer,
where the insurer agrees to pay a designated beneficiary a sum of money upon the occurrence
of the insured individual's or individuals' death or other event, such as terminal illness or critical
illness. In return, the policy owner agrees to pay a stipulated amount called a premium at
regular intervals or in lump sums. There may be designs in some countries where bills and
death expenses plus catering for after funeral expenses should be included in Policy Premium.

As with most insurance policies, life insurance is a contract between the insurer and the policy
owner whereby a benefit is paid to the designated beneficiaries if an insured event occurs which
is covered by the policy.

The value for the policyholder is derived, not from an actual claim event, rather it is the value
derived from the 'peace of mind' experienced by the policyholder, due to the negating of
adverse financial consequences caused by the death of the Life Assured.

To be a life policy the insured event must be based upon the lives of the people named in the
policy.

Insured events that may be covered include:

 Serious illness

Life policies are legal contracts and the terms of the contract describe the limitations of the
insured events. Specific exclusions are often written into the contract to limit the liability of the
insurer; for example claims relating to suicide, fraud, war, riot and civil commotion.

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 7.1.2 Unique and basic characteristics of life insurance contracts

Dear students!!! Would you discuss about unique and basic characteristics of life
insurance contracts?

The distinct features of life insurance, which segregate/differentiate them from other
categories of insurance contracts are as follow.
o They are long – term (i.e. one can buy life insurance contracts even for the
next 90 or 100 years
o They are not subject to the principles of indemnity (i.e. paying or
determining actual compensation upon the death of insured maybe too
difficult or impossible at all)
o They generate so much more investment opportunities for the insurer (i.e.
since for the next 99 or 100 year of insurance contract , premiums are
collected in advance, and the collected premiums are allocated for
investment decisions)
o There are three parties in the contract i.e. the insured, the beneficiary i.e.
third party and the insurance company i.e.
o The policy holder (insured) is different from the beneficiary
o The exposure to be insured - which is death -is inevitable – i.e. 100% sure to
happen, where is property insurance contract the risk e.g. car accident may
or may not happen in the stated period of the insurance contract.
o The gross premium to be paid for life insurance contracts depends upon age,
sex, health conditions (part, current, or future, occupation, marital status,
educational level, service (experience) period, habits, hobbies, hygiene,
death mortality rate, managerial position, status, and authority, current
business engaged in, physical/mental/ psychological make up, etc of the
insured.

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 Section two

Basic types of life insurance contracts

Section overview
There is no one best way to classify life insurance contracts . However ,on the basis of
premium to be paid, time period of the contract, willingness of the insured, saving and amount
of compensation payments to be paid, life insurance contracts are divided in to temporary
term life insurance contracts, whole life insurance contracts , and endowment life insurance
contract s

Objectives of this section

After completing this section, you will be able to:
Define the different types of life insurance contracts
Elaborate basic ways to divide or categorize life insurance contracts
Mention basic differences and similarities that exist among different types of life insurance
contracts .

Outline of this section

1. Temporary term life insurance contracts
2. Whole life insurance contracts
3. Endowment life insurance contract s

7.2.1 Temporary term – life – insurance contracts

 Are short –term life insurance contracts which lasts for few or more years
 Are short term life insurance contracts made between the insurer i.e. insurance
company in which case ,the insurance company pays the face value of the contract
I.e. amount of compensation written in the contract to the 3rd party beneficiary if
the insured dies with in the stated short period of the contract

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Temporary term assurance provides life insurance coverage for a specified term of years in
exchange for a specified premium. The policy does not accumulate cash value. Term is generally
considered "pure" insurance, where the premium buys protection in the event of death and
nothing else.

There are three key factors to be considered in term insurance:

1. Face amount (protection or death benefit),

2. Premium to be paid (cost to the insured), and
3. Length of coverage (term).

Various insurance companies sell term insurance with many different combinations of these
three parameters. The face amount can remain constant or decline. The term can be for one or
more years. The premium can remain level or increase. A common type of term is called annual
renewable term. It is a one year policy but the insurance company guarantees it will issue a
policy of equal or lesser amount without regard to the insurability of the insured and with a
premium set for the insured's age at that time. Another common type of term insurance is
mortgage insurance, which is usually a level premium, declining face value policy. The face
amount is intended to equal the amount of the mortgage on the policy owner’s residence so
the mortgage will be paid if the insured dies.

A policy holder insures his life for a specified term. If he dies before that specified term is up,
his estate or named beneficiary receives a payout. If he does not die before the term is up, he
receives nothing. In the past these policies would almost always exclude suicide. However, after
a number of court judgments against the industry, payouts do occur on death by suicide
(presumably except for in the unlikely case that it can be shown that the suicide was just to
benefit from the policy). Generally, if an insured person commits suicide within the first two
policy years, the insurer will return the premiums paid. However, a death benefit will usually be
paid if the suicide occurs after the two year period.

Basic features of term life insurance contracts

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 - Relatively Short – term i.e. time period of the contorted

- Require relatively smiles premium to be paid

- Offer only compensation i.e no saving benefit

7.2.2 Whole life insurance contracts

Are long –term life insurance contracts which lasts for longer years
Are long term life insurance contracts made between the insurer i.e. insurance
company in which case ,the insurance company pays the face value of the contract I.e.
amount of compensation written in the contract to the 3rd party beneficiary if the
insured dies with in the stated long period of the contract

The primary advantages of whole life are guaranteed death benefits, guaranteed cash
values, fixed and known annual premiums, and mortality and expense charges will not reduce
the cash value shown in the policy. The primary disadvantages of whole life are premium
inflexibility, and the internal rate of return in the policy may not be competitive with other
savings alternatives. Also, the cash values are generally kept by the insurance company at the
time of death, the death benefit only to the beneficiaries. Riders are available that can allow
one to increase the death benefit by paying additional premium. The death benefit can also be
increased through the use of policy dividends.

Dividends cannot be guaranteed and may be higher or lower than historical rates over time.
Premiums are much higher than term insurance in the short-term, but cumulative premiums
are roughly equal if policies are kept in force until average life expectancy.

Cash value can be accessed at any time through policy "loans". Since these loans decrease the
death benefit if not paid back, payback is optional. Cash values are not paid to the beneficiary
upon the death of the insured; the beneficiary receives the death benefit only. If the dividend
option: Paid up additions is elected, dividend cash values will purchase additional death benefit
which will increase the death benefit of the policy to the named beneficiary.

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 Basic features of whole life – insurance contracts
Relatively long – term i.e. time period of the contract to long
- Require relative much more premiums payment
- Offer only compensating benefits i.e. no saving benefits
- Refiner relatively so mum more premium to be paid saving benefit double benefits
compensation & or + saving benefit that – you will win if you die or service.

7.2.3 Endowment life – insurance contract s

-Are long –term life insurance contracts which lasts for longer years
-Are long term life insurance contracts made between the insurer i.e. insurance
company in which case
i) The insurance company pays the face value of the contract I.e. amount of
compensation written in the contract to the 3rd party beneficiary if the insured dies
with in the stated long period of the contract( and this contract is called Pure
endowment life in contract

ii) The insurance company pays the face value of the contract I.e. amount of
compensation written in the contract to the insured if the insured survives s with in
the stated long period of the contract ( and this contract is called ordinary endowment
life insurance contracts)

Section three

Premium determination under life insurance contracts

Section overview
Premium is the money that individuals must pay so as to become customers of an insurance
company. However, the gross s premium which is to be paid by each insured is expected to
cover the total predicted/expected monetary loss to be faced on the death of insured’s and the
costs of doing insurance business. So this section of the module discusses about the meaning
and basic categories of gross premium.

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Key terms, terminologies, and concepts to be used in this section
Total expected death claims
- is the total predicted/expected monetary loss to be faced on the death of insured’s
- Is a total expected monetary compensation to be paid by the insurance company
- calculated as
= total number of insureds who die with in the contract period X the face value of the
contract/policy
Face value of the contract/policy
Is the maximum amount of compensation written in the insurance contract
Gross premium
Is the total premium to be paid by each insured so as to become the customer of an
insurance company
Mortality rate
Is the death rate or probability of dying at a given age

Section objectives
After completing this section, you should be able to :
Understand the term gross premium
Identify factors to be considered while determining gross premium
Elaborate components and types of gross premium
Identify possible ways of determining premium calculations under different types of life
insurance contracts
Section out line
1. Gross premium –key concepts and components
2. Important factors under gross premium
3. Premium determination under term life insurance contracts
4. Premium determination under endowment life insurance contracts

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7.3.1 Key concepts and components of gross premium under life insurance contracts
Gross premium(GP)
A) Is the total premium to be paid by each insured so as to become the customer of an
insurance company
B) Is designed to keep the insurance contract in force/valid
C) Is designed to cover both total expected death claims and total costs/expenses of
doing/offering insurance businesses
D) Is a sum of net premium that means pure premium(pp) and costs/expenses of
doing/offering insurance businesses

Formula for gross premium

N.B GP = PP + costs/expenses of doing/offering insurance businesses
= PP + loading %
= Net premium + loading % or
= pp
1- Loading%
Gross premium can be divided in to two
1. Net premium that means pure premium and
2. costs/expenses of doing/offering insurance businesses
1. Net premium

- Is also called pure premium

- Is designed to cover only the total predicted/expected monetary loss to be faced
on the death of insureds
-Is not designed to cover costs/expenses of doing/offering insurance businesses
incurred by the insurance company
N.B Net premium can be divided in to two
A) Net single premium(NSP)
-Is the net premium to be paid as a single sum i.e just at once at the beginning of the

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 contract period .
Formula
NSP = Total present value(pv) of total expected death claims
Total number of insureds at the beginning of the contract
Where , Total present value(pv) of total expected death claims =
Total expected death claims
( 1 + i)n
Where,
i =interest rate
n= time period of the contract
B) Net level premium(NLP)
-is the net premium to be paid on or as periodic basis rather than just at once through
out the period of the insurance contract

Formula
NLP= NSP
Present value of birr 1 premium per insured
2. Costs of doing insurance business
-refers to expenses incurred by the insurance company while offering insurance services
to insureds
Is not designed to cover total expected death claims
Is expressed as % 0f gross premium
Is also called loading %
Include expenses like
Promotion, light, water, telephone, printing, distribution, commission, profit
allowances,rent,tax,guards,lawyers,accountants,
workers/managers/janitors/secretary/actuary/underwriters, miscellaneous expenses,
etc…

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 7.3.2 Important factors to be considered by insurance companies while
determining/calculating the gross premium that insureds must pay.
Some of the crucial issues to be considered while determining life insurance contracts
under life insurance contracts are
Age of the insured
Gender/sex of the insured
Mortalty rate ,Interest rate
Amount of face value,Time period of the contract
Total number of insureds existing at the beginning of the contract
Total expected death claims ,Total present value(pv) of death claims

7.3.3 Premium determination under term life insurance contracts

Imagine that Ethiopian insurance corporation sales term life insurance contracts for male
insureds at age 40,41 and 42.
Suppose also the fact that the following are the most important factors to be considered by the
stated insurance company while offering/selling term life insurance contracts
Time period of the contract=three years
Total number of insureds at the beginning of the contract period=2,000 insureds
Sex of insureds =male
Age of insureds=age 40,41 and 42
Number of insureds dying at age 40,41 and 42 is 10,15 and 25 respectively.
Face value of the policy/contract=20,000Birr
Interest rate =6%
Costs of doing insurance business=20%
Re –considering the above facts, respond to the following questions
1. Total number of insureds who will die in the contract period
Answer=10+15+25 =50 insureds
2. Total number of insureds who will survive on the expiry date of the contact period

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 Answer = Total number of insureds at the beginning of the contract period minus Total
number of insureds who will die in the contract period
2,000_50= 1,950 insureds
3. The total expected monetary compensation that means total death claims to be paid by
the insurance company to the beneficiaries –third parties

Answer
= total number of insureds who will die with in the contract period X the face value
of the contract/policy
=50 insureds x 20,000Birr= 1,000,000 Birr
4. The total present value (pv) of total expected monetary compensation that means total
death claims to be paid by the insurance company

Answer= Total present value(pv) of total expected death claims =

Total expected death claims
( 1 + i)n
1,000,000 Birr
(1+0.06)3
= 839, 619.28 Birr

5. Net single premium (NSP) to be paid by each insured

Answer = NSP = Total present value(pv) of total expected death claims

Total number of insureds at the beginning of the contract

= 839, 619.28 Birr

2,000 insureds

= 419.81 Birr

6. Gross premium to be paid by each insured

Answer= Net single premium =419.81Birr =

1-loading% 1-0.2

= 524.76 Birr

7. Costs of doing insurance business

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 Answer= Gross premium(GP) =
PP i.e NSP + costs/expenses of doing/offering insurance
businesses
So costs/expenses of doing/offering insurance businesses= GP-PP i.e NSP
= 524.76Birr- 419.81 Birr
= 104.952 Birr
Or costs of doing insurance business is 20% of GP which is =20%(524.76
Birr)=104.952Birr

7.3.4 Premium determination under endowment life insurance contracts

Imagine that Ethiopian insurance corporation sales term life insurance contracts for male
insureds at age 80,81 ,82, 83,84,85,86,87,88,89,90,91,92,93 and 94.
Suppose also the fact that the following are the most important factors to be considered by the
stated insurance company while offering/selling endowment life insurance contracts
Time period of the contract=15 years
Total number of insureds at the beginning of the contract period=4,000 insureds
Sex of insureds =male
Age of insureds=age 80,81 ,82, 83,84,85,86,87,88,89,90,91,92,93 and 94.
Number of insureds dying at age 80,81 ,82, 83,84,85,86,87,88,89,90,91,92,93 and 94 is
20,25,31,36,43,48,55,60,66,74,80,86,94,99,and 103 respectively.
Face value of the policy/contract=40,000Birr
Interest rate =8%
Costs of doing insurance business=20%
Re –considering the above facts, respond to the following questions
1. Total number of insureds who will die in the contract period
Answer= =20+25+31+36+43+48+55+60+66+74+80+86+94+99+ 103 = 920 insureds
2. Total number of insureds who will survive on the expiry date of the contact period
Answer = Total number of insureds at the beginning of the contract period minus Total
number of insureds who will die in the contract period
4,000_920= 3,080 insureds

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 3. The total expected monetary compensation that means total death claims to be paid by
the
insurance company to the beneficiaries under pure endowment life insurance
contracts

Answer=
= total number of insureds who will die with in the contract period X the face value
of the contract/policy
=920 insureds x 40,000Birr= 36,800,000Birr

4. The total present value (pv) of total expected monetary compensation that means total
death claims to be paid by the insurance company to the beneficiaries under pure
endowment life insurance contracts

Answer= Total present value(pv) of total expected death claims =

Total expected death claims
( 1 + i)n
36,800,000Birr
(1+0.08)15
= 11,600,896 Birr

5. Net single premium (NSP) to be paid by each insured under pure endowment life
insurance contracts

Answer = NSP = Total present value(pv) of total expected death claims

Total number of insureds at the beginning of the contract
= 11,600,896 Birr

4,000 insureds

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 = 2,900.224Birr

6…….Gross premium to be paid by each insured

under pure endowment life insurance contracts

Answer= Net single premium

1-loading%

= 2,900.224Birr

1-0.2

= 3,625.28 Birr

7…..Costs of doing insurance business to be charged under pure endowment life insurance contracts

Answer= Gross premium(GP) =

PP i.e NSP + costs/expenses of doing/offering insurance
businesses
So costs/expenses of doing/offering insurance businesses= GP-PP i.e NSP
= 3,625.28 Birr-2,900.224Birr

= 725.056 Birr
0r costs of doing insurance business is 20% of GP =20%( 3,625.28 Birr)=725.056Birr
8….Total saving benefits to be paid to the surviving insureds on the expiry date under
ordinary endowment life insurance contracts
Answer =total number of insureds surviving on the expiry date of the contract X Face
value of the policy
= 3,080 insureds x 40,000Birr
= 12,320,000,000 Birr

Summary

Life insurance provides a monetary benefit to a decedent's family or other designated

beneficiary, and may specifically provide for income to an insured person's family, burial,
funeral and other final expenses. Life insurance policies often allow the option of having the
proceeds paid to the beneficiary either in a lump sum cash payment or an annuity.

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Some of the unique characteristics of life insurance include they are long term, they are not
subject to the principles of indemnity and the event to be ensured is sure to happen.

There is no one best way to classify life insurance contracts . However ,on the basis of
premium to be paid, time period of the contract, willingness of the insured, saving and amount
of compensation payments to be paid, life insurance contracts are divided in to temporary
term life insurance contracts, whole life insurance contracts , and endowment life insurance
contract s

Gross premium is the total premium that each insured must pay so as to become customer of
an insurance company and is designed to cover both expected total death claims and costs of
doing insurance business.

Review questions

1. What is meant by personal risk(s)?

2. Differentiate the term personal risk from property and liability
risks?
3. Describe the basic concepts and unique characteristics/features of
life insurance contracts?
4. What types of risks and exposures are expected to be insured
under life insurance contracts?
5. Mention the different types of life insurance contracts?
6. Specify also basic exposures to be insured under the different
types of life insurance contracts?
7. What are the most important criterion used to classify life
insurance contracts?
8. What are the most important similarities and differences that exist in among the
different types of life insurance contracts?
9. Differentiate between pure endowment and ordinary endowment life insurance contracts?

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10. Under different types of life insurance contracts, what are the most important factors to
be considered while determining premium?

References
Chris Morrison, Fundamentals of Risk Management, 3 ed.2008 Mc Graw Hill company ,USA
Dofman, Marts, Introduction to Risk Management and Insurance,9th ed. 2007 Mc Graw Hill
company ,USA
Emmet and Therse, Vugen, Essentials of Risk Management and Insurance, 2 nd ed, 2002 Jhon
Willey and Sons [Link] Singapore
Harrington,Scott and Nilhause ,Risk Management and Insurance,2nd ed,[Link] Graw Hill
company ,USA
James lam, Enterprise Risk Management,2003, JhonWilley and Sons,USA

Michael croochy, Dangalov,Robert Mark ,Risk Management,2001,McGraw Hill ,USA

Rejda, George, Principles of Risk Management and Insurance,10th ed.,2004,Pearson
International ed.,USA

Skipper, Harold and W. Jee ,Risk Management and Insurance: Perspectives in a Global
Economy,2007, Black well Publishing,Australia
Trieschmann, Hoyt and sommer,Risk Management,12 th ed. 2005, South Western ,USA

136
 Unit eight

Insurance business in Ethiopia

Learning objectives

After completing this unit ,you will be to:

Evolution of insurance business in Ethiopia

Development and trend in insurance business in Ethiopia
Major problems in insurance business in Ethiopia
Unit out line
1. Evolutions and developments of insurance business in Ethiopia
2. Major problems in insurance business in Ethiopia

8.1 Evolutions and developments of insurance business in Ethiopia

Dear students !!! What do you know about the evolutions and developments of
insurance business in Ethiopia ?

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Traditional protection of risk in Ethiopia can be found in the form of Edir and Equib where
people get in some financial contribution to save them selves and losses of properties from
unexpected trouble in the future.

Insurance business in modern sense in Ethiopian started in 1905 when the bank of Abyssinia (a
branch of bank of Egypt) started underwriting fire and marine insurance policies on behalf of a
foreign insurance company as their agent.

In 1923, a branch of foreign insurance company known as “Baloise fire insurance company” was
opened by an Austrian national called Weinzinger in Addis Abeba.

For the first time in Ethiopia Baloise fire insurance company paid compensation to a client in
1936 for damage to insured store caused by fire .Beginning from this time until the Italian
invasion of 1936 some foreign insurance companies were operating through their agents.
During the Italian occupation of Ethiopia in 1936-1941 , Italian insurance companies operated
and non-Italian companies were closed down .Soon after second world war , a number of
western insurance companies started using polices through agency 0ffices. The first motor
policy was issued by south British company in 1947.

Until 1950, almost practically all or 99% of the policy holders were foreigners or foreign
companies . In 1951, opening a new chapter in the history of Ethiopian Insurance industry , the
first local company called the Imperial insurance company was formed .

For two decades , there after , local company’s as well as agents of foreign insurance companies
were operating without adequate legal guidelines. The only legal provision available was the
1960 commercial and maritime codes.

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The insurance proclamation 281/ 1970 managed to outline the manner under which insurance
companies should have been formed and what control procedures they had to fulfill while
operating.

Proclamation No. 281/1970 gave the responsibility of controlling the insurance business to the
Ministry of Trade and Industry . Based on the provision of the proclamation a council was
established chaired by the Minister of Ministry of Trade and Industry. The main objectives of
this council was to encourage and control the insurance business and to formulate polices that
enhance insurance and investment .Under the council the office of the controller of insurance
was established. This office licensed 15 domestic insurance companies , 36 agents , 7 brokers ,
11 loss assessors , and 3 actuaries.

As a result of the 1970 proclamation 16 insurance companies were licensed , out of which 3
were discontinued, thus leaving 13 insurance companies operating till the end of 1974.

In 1974, the military government come to power and nationalized all the 13 insurance
companies that were operating in the country. The boards of all the nationalized companies
were dissolved and a new provisional insurance Board was set up . The nationalized companies
were operating independently but were required to report to the provisional insurance board .

The Ethiopian insurance corporation was established under proclamation No. 68/ 1975 with a
paid up capital of 11 million dollars. The assets, liabilities , rights, and obligations of the
nationalized private insurance companies were transferred to the Ethiopian insurance
corporation. The purpose of the corporation were :
 To engage in all classes of insurance business in Ethiopia
 To ensure that insurance services reach the board masses of people ; and
 To promote efficient utilization of both material and financial insurance resources.

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The Ethiopian Insurance corporation operated as a sole insurance organization until 1994.

Following the change of government in 1991 a new economic policy that increased the role of
the private sector in the economy was formulated . A new and comprehensive law to regulate
the licensing operation and supervision of insurance business was promulgated by the
transitional government of Ethiopia under proclamation No. 86/1994.
Under this legislation the task of the licensing and supervision of insurance business was given
to the National Bank of Ethiopia .

The law allowed private companies whose capital is wholly owned by Ethiopian nationals and /
or organizations wholly owned by Ethiopian nationals and registered under the laws of and
have their head office in Ethiopia to engage in insurance business.
Proclamation No. 86/1994 further provides that the minimum share capital is Birr 3 million for
general insurance business , Birr 4 million for long term insurance business , and birr 7 million if
the business to be done is both general and long term insurance business.
Following the proclamation No. 86/1994(a proclamation to provide for the licensing and
supervision of insurance business) there are now 9 private insurance companies and one
government owned Insurance Corporation. They are:

Ethiopian insurance corporation (EIC) – government owned.

National insurance company of Ethiopia (NICE)
 United insurance company
 Nile insurance company
African insurance company
 Nyala insurance company
Global insurance company
Lion insurance company
Awash insurance company

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 Nib insurance company

The majority of the above insurance companies have re-insurance arrangements with reputable
international insurers mainly from Munich Re, Swiss, etc.

8.2 Major problems in insurance business in Ethiopia

Dear students !!! What do you know about the major problems of insurance business in
Ethiopia ?

Though there is a growing performance in the industry over the last few years , the industry is
facing some problems . The major problem of the existing insurance companies in Ethiopia to
day are listed below in order of importance:
 Lack of adequate public awareness
 Shortage of skilled man power

 Price cutting

 Lack of professional ethics

 Unfavorable polices

 Lack of proper data to conduct business analysis.

Summary

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Insurance business was started in Ethiopia during the period of Menelik the Second and during
the Majesty Period there were large number of insurance companies operating business in
Ethiopia and during the period of Mengistu Haile Mariam there was only one insurance
company which was the Ethiopian insurance corporation and now in the EPRDF regime there
are more than fifteen different insurance companies in Ethiopia .some of the basic factors that
hinder the growth of insurance business in Ethiopia inclue lack of public awareness and
shortages of skilled man power in this field of study.

142
Review questions

1. Discuss the time period in which insurance business started in Ethiopia.

2. Identify the first foreign/ indigenous -local insurance company in Ethiopia
3. Discuss the roles of ministry of trade and industry towards insurance business during the
period of Haile sellsies and Derge regime.
4. Discuss the history/date of establishment/number/types/ nature/roles /locations/number
of branches/ types of contracts/ degree of competion in insurance industry and status of
ownership of insurance companies
under/during the period of
- Haile sellsies
- Derge regime
and now EPRDF regime
5. Describe the basic roles of National Bank of Ethiopia towards insurance business in Ethiopia
6. Predict the future trends and scenarios of insurance business in Ethiopia
7. What are the most important factors that influence the growth of insurance busines in
Ethiopia
8. Describe or find out number of private and governmentally owned insurance companies in
Ethiopia and specify also their respective re-insurance companies in which they get reinsurance
services.

143
JIMMAA UNIVERSITY
COLLEGE OF BUSINESS AND ECONOMICS
DEPARIMENT OF MANAGEMENT
Assignment for the course Riske management MGMT
ASSIGEMENT FOR DISTANCE LEARNERS
MAX MARKS 30%
ACADEMIC YEAR 2010
NAME_________________________________
ID_____________________________________
Department______________________________
Center____________________________________
Year _____________________________________
Term____________________________________
General Instructions
This assignment booklet has five parts and respond to them accordingly

144
Part one: Say True or False
Write true if the statement is correct and false if te statement is wrong (0.25
point each =10x0.25points)
________1.The term risk refers to the doubt that people have towards the
Occurrence of accident
________2. When compared with fundamental risks particular riske offect large number of
_________3.The word hazazard refers to the specific cause of an accident
__________4.Risk can be categorized in to different classes on the basis of time cause and
impact
___________5. The potential sources of identifying risks include insurance
policy check lists and the questionnaire method.
_________6.Insurance is a process of transferring risks from on individual to an insurance
________7. The legal principles of an insurance contract are optional principles to be considered
while signing or purchasing an insurance contract.
_________8. Liability insurance contracts gives indemnity for deliberate accidents made to other
persons or their property.
_________9. Life insurance contracts are necessarily subject to the principles of subrogation.
__________10.when compared with life insurance contracts, property insurance contracts are
short term in nature

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Part two: Choose the best answer
Choose the best answer and write the letter of your response in the space
provided ( 0.5 point each=22x0.5=11point)
-------------[Link] the context of insurance, the cost of doing insurance businesses is
A. Is solely covered by insurance companies
B. Can be accurately determined after the occurrence of loss
C. Doesn.t vary with the amount of premium to be charged for a given exposure
D. A & C are answers
E. None of the above are answer
_________2.One of the following one will have direct relationship with the premium to be
charged
A. Value of exposure
B. Size of loss
C. Time period of the contract
D. B&C are answers
E. All are answers
______________3.when compared with pricing of certain products, insurance pricing
A. Is based on market competition
B. Is based on loss predication
C. Is highly prone to governmental regulations
D. A & B are answers
E. B and C are answers
___________ 4. Risk management
A . Involves managing risks before they occur
B. is all about preventing the occurrence of accidental risks
C . is post action
D .A & B are answers
E . all are answers

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______________5 the prerequisites to insurance contract include
A. Minor lasses
B. Intentionally occurring risks
C. Edstence of much exposures under a give insurance contract
D. A AND B are answers
__________6. Loss retention is best recommended when
A. the predicted loss is so small
B. the value of exposure insignificant
C. Premium to be charged for an exposure exceeds the value of the exposure
D. A % BN are correct E. All are answers
__________7. the consequences of the existence of insurance services include
A. Becoming indifferent as to the occurrence of loss of accident
B. Gatting peace of mind
C. Deliberately destroying insured properties and claiming for such losses
D. B & C are answers E . All are answers
__________8. Abstaining from possessing any property and ceasing current business is relate to
A . loss retention B . Avoidance
C. Combination D. Separation . E. Insurance
_________9. An insurance company which sells contract and offers guarantee for an individual
who engage in illegal drug is supposed to violate the principle of
[Link]
B. Subrogation
[Link] interest
[Link] good faith
E. Contribution
__________10. According to the principles of subrogation, an insured can
A. Collect compensation from the wrong doer
B. Sue &brought the wrong deer to the court
C. Can claim doughy compensation both from the in surer and wrong doer
D. A and B are answers E. None of the above are answers

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 __________11. The gross premium to be charged for a given exposure can be determined
accurately
A. After the occurrence of loss
B. Before the expiry date of the contract C. Before the occurrence of loss

D. After the expiry date of the contract E. None of the above are answers
________12. All of the following may relate to the concept of risk except
A. Tension
B. Dilemma
C. Existence of no deviation between actual and derived loss
D. Uncertainties E .None of the above are answers
-----------------13. The basis to classify insurance include
A. nature of property to be insured
B. possible damages made to people
C. death of an individual
D. A & B are answers
E. All are answer

____________14 as a risk identification mechanism onsite inspection relates to

A. Concurrent action
B. Post action
C. Pre-action
D. None of the above are answers

____________15.the basic objective of life insurance contract is

A. Rescuing an insured from death
B. Setting claims upon death
C. Generating investment opportunities for insurance companies
D. B and C are answers
E. None of the above are answer

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____________16.from insurance companies point of view, accident to be insured are
A. Minor
B. Deliberate
C. Non-fortuitous
D.B and C are answers
E. None of the above are answers
_____________17.the principle of utmost good faith will not be violated provided an insured
A. A. Claim for the loss occurred after the expiry date of the contract
B. B. That he has caused intentionally
C. C. Suffer an accident whose peril is mentioned in the contract
D. D. Make and submit fraudulent claims
E. E .All are answers

____________18.accordin to the principle of indemnity, an insured can claim on loss

compensation
A. Which is stated in the contract regardless of the amount of actual loss
B. Which exceeds the total value of the exposure stated in contract
C. Which commensurate actual loss occurred
D. A and B are answers E. All answers
______________19. Rick measurement
A. Is a primary risk management process
B. Involves measuring losses occurred in the past
C. Involves quantifying the consequences of predicted losses which will occur in the future
D. All except are answers
E. All are answers

_______________20. Risk can be classified on the basis of

A. Impact
B. Cause
C. Measurability
D. Controllability
E. All are answers

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________________21. The recommended risk management tools which are used to safeguard
properties located in catastrophic area include
A. Self-insurance B. Neutralization C. Combination

D. Avoidance
________________22. Pick out the right combination
A. Insurance-- amount of predicted loss too small
B. Separation-- pooling of all owned exposures
C. Avoidance--scattering of all owned exposures
D. A and B are answers
E. None of the above are answers

Part three -----Matching

Match terms under column “A” with terms under column “B” (0.25 point each
10*0.25=2.5 points)
“A” “B”

1. Peril A. An insurance contract which offers indemnity for loss of

money
2. Risk identification B. Specific cause of an accident

3. Property risk C. Money paid by insurrects to an insurance company

4. Insurable risk D. The first step in risk management

[Link] E. Short term life insurance contracts

[Link] contract F. Risks which affect the value of properties

7. Aviation insurance contract G. An insurance contract which offers indemnity for loss of air
plane
[Link] life insurance contract H. An agreement between the insured and insurer

9. Premium I. Risks that insurance companies are willing to accept & insure

[Link] guarantee insurance J. The worst risk that all people face
contract

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Part four: Discussion questions (2points each =2*4=8points)
1. Discuss briefly about the various categories of risk (2point)
2. Mention briefly the meaning and basic categories of liability of insurance contracts (2 points)
3. Elaborate briefly the meaning, need for and the basic categories of legal principles of an
insurance contract (2points)
4. Discuss briefly the meaning, features and basic categories of life insurance contracts (2points)

Part five: case type question (6points)

Consider the organization that you are currently serving or select any
organization that you are familiar with and then respond to the following
question accordingly
1. Discuss on the risk management process used by the organization to control the occurrence of
risk (1 point)
2. Elaborate briefly on the potential mechanisms used by the organization to identify risk, specify
also the types of risks faced by the organization (1 points)
3. Mention briefly the basic approaches used by the organization to measure risks in the
organization (1 point)
4. Discuss briefly over the risk control and risk financing and risk financing tools used by the
organization (1points)
5. What are the specific advantages and objectives of risk management program adopted by the
organization (1 point)
6. Figure out and then compare and contrast the basic problems that you have identified in the
risk management program used by the organization and suggest new solution or approaches (1
points)

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