Introduction to risk

management and
insurance
CHAPTER 1
Outline
1.1 Risk management
1.1.1 Concept of risk
1.1.2 Risk management process
1.2. Principles of insurance
1.2.1 Nature and Functions
1.2.2 The fields of insurance
1.2.3 Insurance industry and regulation
1.1 Risk management
1.1.1 Concept of risk
1.1.2 Risk management process
1.1.1 Concept of risk
• Define and explain the meaning of the term risk
• Distinguish among the terms: risk, peril, and hazard
• Identify and explain the classes of hazards
• Differentiate between pure risk and speculative risk
• Describe the categories into which pure risk may be
subdivided
1.1.1 Concept of risk
Risk: a condition in which there is a possibility
of an adverse deviation from a desired outcome
that is expected or hoped for.
Peril: a cause of a loss
Hazard: a condition that may create or increase the chance
of a loss arising from a given peril
Hazard vs
Risk
Classifications of hazards
Three categories of hazards:
1. Physical hazards
2. Moral hazard : a conscious change in behavior to try to
benefit from an event that occurs.
3. Morale hazard: an unconscious change in a person's
behavior when he is insured.
Classifications of risk
Pure risk and speculative risk
1. Pure risk: the situations that involve only the chance of
loss or no loss
2. Speculative risk: a situation in which there is a possibility
of loss, but also a possibility of gain.
What kind of risks are insurable?
Pure risk and speculative risk
•Only pure risks are insurable.
•Speculative risk is voluntarily accepted
•Not all pure risks are insurable
Classifications of Pure Risk
1. Personal risks
2. Property risks
3. Liability risks
4. Risks arising from failure of others
1. Personal risks
These consist of the possibility of loss of income or assets as a result
of the loss of the ability to earn income.
In general, earning power is subject to four perils:
(a) premature death
(b) dependent old age
(c) sickness or disability
(d) unemployment
2. Property risks
Anyone who owns property faces property risks simply
because such possessions can be destroyed or stolen.
Property risks involve two types of losses:
(a) the loss of the property
(b) loss of use of the property: resulting in lost income or
additional expenses
3. Liability risks
Liability risks involve the possibility of loss of present assets
or future income as a result of damages assessed or legal
liability arising out of either intentional or unintentional
torts, or invasion of the rights of others.
The one who has injured another, or damaged another’s
property through negligence or otherwise, can be held
responsible for the harm caused.
4. Risks arising from failure of others
When another person agrees to perform a service for you,
he or she undertakes an obligation that you hope will be
met.
When the person’s failure to meet this obligation would
result in your financial loss.
Eg : failure of a contractor to complete a construction
project as scheduled, or failure of debtors to make
payments as expected.
1.1.2 Risk management process
• Define and explain what is meant by the term risk management
• Identify the two broad approaches to dealing with risk that are
recognized by modern risk management theory
•Describe risk management process
Definition of Risk management
Risk management is a scientific approach to dealing
with pure risks by anticipating possible accidental
losses and designing and implementing procedures
that minimize the occurrence of loss or the financial
impact of the losses that do occur.
Risk management tools
Risk avoidance
Risk control
Risk reduction
Risk management
Risk retention
Risk financing
Risk transfer
Risk management tools
Include two broad approaches:
(1) Risk control: focuses on minimizing the risk of loss
(2) Risk financing: focuses on finding funds to meet losses
(1) Risk control
A. Risk avoidance : decisions are made that prevent a risk
from even coming into existence.
Risk avoidance should be used in those instances in which
the exposure has catastrophic potential, and the risk cannot
be reduced or transferred
Risk avoidance is a negative rather than a positive approach.
It is used when there is no other alternative.
(1) Risk control
B. Risk reduction: loss prevention & loss control
Loss prevention : the emphasis of loss prevention is on
preventing the occurrence of loss
Loss control: measures focus on lessening the severity of
those losses that actually do occur.
(2) Risk financing
Risk financing focus on arrangements designed to guarantee
the availability of funds to meet those losses that do occur.
A. Risk retention: Intentional and unintentional
B. Risk transfer: Insurance
1.2. Principles of insurance
1.2.1 Nature and Functions
1.2.2 The fields of insurance
1.2.3 Insurance industry and regulation
Nature of Insurance
•By nature, insurance is a devise of sharing risk by large
number of people among the few who are exposed to risk
by one or the other reason.
•Insurance provides facility of financial help in case of
contingency.
•Insurance is a policy regulated under laws and therefore
the amount of insurance can neither be paid as gambling
nor as charity.
Primary Functions
[Link] protection: The primary function of insurance is to protect against future risk,
accidents, and uncertainty. Insurance cannot check the happening of the risk but can certainly
provide for the losses of risk. Insurance is actually a protection against economic losses, by
sharing the risk with others.
[Link] Bearing of Risk: Insurance is a device to share the financial loss of a few among many
others. Insurance is a means by which few losses are shared among a larger number of people.
All the insured contribute the premiums towards a fund and out of which the persons exposed
to a particular risk are paid.
[Link] of Risk: Insurance determines the probable volume of risk by evaluating various
factors that give rise to risk. The risk is the basis for determining the premium rate also.
[Link] Certainty: Insurance is a device, which helps to change from uncertainty to certainty.
Insurance is a device whereby the uncertainty risk may be made more certain.
Secondary Functions
[Link] of Losses: Insurance cautions individuals and businessmen to adopt
suitable devices to prevent unfortunate consequences of risk by observing safety
instructions; Prevention of losses causes the lesser payment to the assured by the
insurer and this will encourage more savings by way of premium. Reduced rate of
premiums stimulates more business and better protection to the insured.
[Link] Capital to cover larger risks: Insurance relieves the businessmen from security
investments, by paying a small amount of premium against larger risks and uncertainty.
[Link] towards the development of larger industries: Insurance provides
development opportunities to those larger industries having more risks in their setup.
Even the financial institutions may be prepared to give credit to sick industrial units that
have insured their assets including plant and machinery.
Other Functions
1. Means of savings and investment: Insurance serves as savings and
investment, insurance is a compulsory way of savings and it restricts the
unnecessary expenses by the insured to avail income-tax exemptions also,
people invest in insurance.
2. Source of earning foreign exchange: Insurance is an international business.
The country can earn foreign exchange by way of the issue of marine insurance
policies and various other ways.
3. Risk-free trade: Insurance promotes exports insurance, which makes the
foreign trade risk-free with the help of different types of policies under marine
insurance.
1.2.2. The fields of insurance
A. Private (Voluntary) insurance: Life insurance, Health
insurance, Property and Liability insurance
B. Social insurance
C. Public Guarantee Insurance Programs
1.2.3 Insurance industry and regulation
1. Basic concepts of insurance
2. Fundamental Principles
CLASSIFICATION OF PRIVATE INSURERS
Three types of insurers based on their product.
❑Life insurance companies sell life contracts and annuities and, in
addition, write health insurance.
❑Property and liability insurance companies market all forms of
property and liability insurance (including health insurance) but do
not write life insurance.
❑Health insurers are a class of specialty insurers, concentrating on
their one area of risk
CLASSIFICATION OF PRIVATE INSURERS
Insurers can be classified by their organizational form:
◦ Joint stock insurance company;
◦ Insurance limited liability company;
◦ Cooperative insurance;
◦ Mutual insurance organization.
Principles of Government inspection of
insurance business
➢Ensure the interests of the insured
➢Guarantee the good ending of the insurance contract
➢Ensure a comprehensive inspection of the activities of insurance
companies
➢Prevention is the main goal
➢Ensuring the international integration of Vietnamese insurance
businesses
➢Conduct within the framework of the law, excluding any arbitrary,
arbitrary intervention of the administration.
Ministry of Finance - managing insurance
business activities in Vietnam
▪Formulate strategies, planning, plans and policies to develop the Vietnam
insurance market;
▪Issuance and withdrawal of establishment and operation licenses of
insurance enterprises and insurance brokerage enterprises; license to set up
representative offices of foreign insurance enterprises and insurance brokers
in Vietnam;
▪Promulgating, approving and guiding the implementation of rules, terms, fee
schedule, and insurance commissions;
▪Apply necessary measures for insurers to ensure financial requirements and
fulfill commitments with insurance buyers;
Ministry of Finance - managing insurance
business activities in Vietnam
▪Organize information and forecast the insurance market situation;
▪International cooperation in the field of insurance;
▪Approving the insurance enterprise's operation abroad;
▪Managing the operation of representative offices of foreign insurance
enterprises and foreign insurance brokerage enterprises in Vietnam;
▪Organize the training, build a team of management and professional staff in
insurance;
▪Inspection and examination of insurance business activities; settle complaints
and denunciations and handle violations of the law on insurance business.
Basic concepts of insurance
Insurer (insurance company): a company that accepts risk and makes a
promise to pay a policy benefit if a loss does occur.
Insured: the person whose life, health or property is insured under the
policy.
Insurance policy (insurance contract): a written document that contains the
terms of the agreement between the insurer and the owner of the policy.
Policy owner: the person or business that owns the insurance policy
A third-party policy: The insurance policy covers damage or liability to
someone other than the policy owner or insured.
Basic concepts of insurance
Beneficiary: the person or party the policy-owner names to receive the
benefit
Claim: a request for payment under the terms of an insurance policy
Premium: the specified amount of money an insurer charges in exchange for
agreeing to pay a policy benefit when a specified loss occurs.
Depreciation: The loss in value over time due to factors such as age and wear
and tear.
Basic concepts of insurance
Actual cash value (ACV) : the amount of money necessary to
replace the damaged or destroyed property with new materials at
present-day prices, less depreciation.
3 main methods to determine
◦ Replacement cost less depreciation
◦ Fair market value - The price a willing buyer would pay a willing
seller in a free market
◦ Broad evidence rule: the determination of ACV should include all
relevant factors an expert would use to determine the value of the
property
Deductible
A deductible is a provision by which a specified amount is
subtracted from the total loss payment that otherwise would be
payable
A deductible is the amount you must pay out of pocket before
your insurance benefits begin. Once you pay the deductible,
then the insurance company will pay the claim.
Deductibles are how risk is shared between you, the
policyholder, and your insurer.
Deductible
The purpose of a deductible
◦Eliminate small claims that are expensive to handle and
process
◦Reduce premiums paid by the insured
◦Reduce moral hazard.
Deductible
Straight deductible: the insured must pay a certain number
of dollars of loss before the insurer is required to make a
payment
Eg: an auto insurance deductible
Aggregate deductible: all losses that occur during a
specified time period, usually a year, are accumulated to
satisfy the deductible amount
Deductible
• Insurance deductibles are common to property and health insurance products
• Deductible values vary based on the coverage, insurer, and premiums.
• The higher the deductible, the lower the premium will be.
• Some insurance policies may have a minimum deductible set by the insurance
company. This is to guarantee that the insureds are responsible for part of the
insurance claim.
• Deductibles help insurers reduce the financial burden of policy losses. Plus,
they keep consumers from filing a bunch of small claims. However, most
policies offer a choice of deductibles so the customer can tailor the coverage
to suit their needs.
Deductible - Examples
You go on vacation and while you’re away a torrential rainstorm causes a
leak to spring from your roof, damaging a large section of your hardwood
floors. You return home to a surprising mess and immediately file a
homeowner’s insurance claim.
After submitting repair estimates, your home insurer approves a $10,000
settlement — but you have a $2,500 deductible. How much will you
receive from your insurer for this loss?
You’ll only receive $7,500 (which is the settlement amount $10,000 minus
the $2,500 deductible)
Deductible in Car insurance & Home
insurance
Car (Auto) insurance policies usually offer deductibles in amounts
such as $200, $500 or $1,000. If you choose $1,000, you’d pay the
first $1,000 in covered damage and your insurer would be
responsible for the remaining amount.
Home insurance also might offer deductibles in flat dollar amounts,
or they can be a percentage of the insured value of your property.
For instance, if your home is insured for $100,000, a 2 percent
deductible means you’d pay the first $2,000 and the insurer would
pick up the rest.
Fundamental Principles
1. Principal of Utmost Good Faith
2. Principle of Indemnity
3. Principle of Contribution
4. Principle of Subrogation
5. Principle of Loss Minimization
6. Principle of Proximate cause
7. Principle of Insurable Interest
1. Principal of Utmost Good Faith
Both parties, insurer and insured should enter contract in good faith.
•If there are any material facts deliberately hidden, the insurer will
consider it as fraudulent and reserves the right to refuse to
compensate in the event of a claim, or to terminate the insurance
contract.
•On the other hand, the insurer will also be truthful in terms of the
ability or inability to cover the said insured objects.
Principle of Utmost Good Faith
Representations are statements made by the applicant for insurance
◦ A contract is voidable if the representation is material, false, and relied
on by the insurer. Material means that if the insurer knew the true facts,
the policy would not have been issued, or would have been issued on
different terms
◦ An innocent misrepresentation of a material fact, if relied on by the
insurer, makes the contract voidable
Principal of Utmost Good Faith
Some applications in insurance:

•Informing about a chronic or hereditary disease suffered when

applying for health insurance.

•Informing about the use of a motor vehicle, whether it is for

personal or commercial use.
Principal of Utmost Good Faith
Example
John took a health insurance policy.
At the time of taking policy, he was a smoker, and he didn't disclose
this fact.
He got lung cancer.
Insurance company won't pay anything as John didn't reveal the
important facts.
 2. Principle of Indemnity
❑Insured can't make any profit from the insurance contract.
Insurance contract is meant for coverage of losses only
❑Indemnity means a guarantee to put the insured in the position as
they was before accident
❑This indemnity principle only apply to property insurance and
liability insurance. It does not apply to the types of insurance in
which the insured object is the life of a person, such as: life, health,
personal accidental, or travel insurances.
 2. Principle of Indemnity
In property insurance, indemnification is based on the actual cash
value (ACV) of the property at the time of loss
A couple of examples of its application in insurance:
• Renovation to a house damaged by fire. Renovation is done only
to the parts of the house which are affected by the fire.
• Compensation for a lost car maximized according to the insured
value if the car is not under-insured.
 3. Principle of Contribution
❑ In case the insured took more than one insurance policy for same
subject matter, he/she can't make profit by making claim for same
loss more than once
❑ The application in insurance is as follows
A luxury car insured by three different insurance companies.
A house insured by several different insurance companies.
 3. Principle of Contribution
The insurance company with the biggest liability portion becomes the
leader while the rest become the members.
The leader is responsible to collect the premiums from the members
and to determine whether to accept a claim and the amount of the
compensation for the claim.
 3. Principle of Contribution
Example:
Robert has a property worth $50,000. He took insurance from
Company A worth $30,000 and from Company B $10,000.
In case of accident, he incurred a loss of $30,000 to the property.
Robert can claim $30,000 from A but after that he can't make profit
by making a claim from Company B.
Now Company A can make a claim from Company B to for
proportional loss claim value.
4. Principle of Subrogation
Subrogation is a term describing a right held by most
insurance carriers to legally pursue a third party that
caused an insurance loss to the insured.
Purpose:
◦To prevent the insured from collecting twice for the same
loss
◦To hold the negligent person responsible for the loss
◦To hold down insurance rates
4. Principle of Subrogation
Examples of its application in insurance:
•In motor vehicle insurance, the insurance company is entitled to
submit a written claim of compensation for the insured to the third
party that causes a loss to the insured.
•In fire insurance, the same applies. If the fire affecting the insured
asset is caused by the spreading of a fire by a third-party asset to its
surroundings, the insurance company is entitled to obtain its
subrogation rights.
4. Principle of Subrogation
The Subrogation Principle in Insurance means when insurer
(insurance company) pays full compensation for any insured loss (of
insured property), the insurer holds the legal right (claim) of the
insured property.
Example:
Ben took an insurance policy for his Car. In an accident his car totally
damaged.
Insurer paid the full policy value to insured. Now Ben can't sell the
scrap remained after receive the insurance benefit.
5. Principle of Loss Minimization
This principle states that the insured must take all the necessary steps
to minimize the losses to inured assets.
❑Example:
Rupert took insurance policy for his house. In a cylinder blast, his
house burnt.
He should have called nearest fire station so that the loss could be
minimized.
6. Principle of Proximate cause (Causa Proxima)
❑An accident may be caused by more than one cause. In case property
insured for only one cause. In such case nearest cause of the accident is
found out.
❑Insurer pays the claim money only if the nearest cause is insured.
❑In case of life insurance, the principle of Proximate cause does not apply.
Whatever may be the reason of death (whether a natural death or an
unnatural death) the insurer is liable to pay the amount of insurance.
Principle of Proximate cause
Example:
A cargo ship’s base was punctured due to rats and so sea water entered,
and cargo was damaged. Here there are two causes for the damage of the
cargo ship.
•The cargo ship getting punctured because of rats.
•The sea water entering ship through puncture.
The risk of sea water is insured but the risk of rat is not. The nearest cause
of damage is sea water which is insured and therefore the insurer must
pay the compensation.
Principle of Proximate cause
Insurance protects against some perils - types of damage -but not others.
Example:
Your house is caught in a hurricane. Your homeowner's insurance protects
against wind damage but not flooding.
If the proximate or primary cause of damage was floodwater, your insurer
will refuse to pay.
If you prove the proximate cause of the damage was the wind, you can
collect.
7. Principle of Insurable interest
•Insurable interest is the principle that defines who can take
out an insurance policy. In insurance law, you can only buy
insurance for something or someone in which you have an
insurable interest.
•Insurable interest means the insured must be in a position
to lose financially if a covered loss occurs
7. Principle of Insurable interest
An insurable interest can be supported by:
•Ownership of property
•Potential legal liability
•Serving as a secured creditor
•Contractual rights
Eg: a person has an insurable interest in their own home or car –
but not those of their neighbor's.
7. Principle of Insurable interest
Purposes:
•To prevent gambling
•To reduce moral hazard
•To measure the amount of the insured’s loss
7. Principle of Insurable interest
Life insurance:
The question of insurable interest does not arise when you
purchase life insurance on your own life
Insurable interest in another person’s life can be shown by
close family ties, marriage, or a pecuniary (financial) interest
Under-insurance
Many insurance policies include an ‘Average’ or ‘Co-Insurance’
clause (also known as the ‘under-insurance’ clause) which means if
you insure for less than the full value of the property, a claim can be
reduced in proportion to the amount of the under-insurance.
Policy Limit (insurance limit): is the maximum amount an insurer will
pay under a policy for a covered loss. Typically, higher limits carry
higher premiums.
Indemnity = Damage x (Insurance Limit / Insured property value)
Under-insurance
An insurance policy has:
Full Replacement Value = $1,000,000; Sum Insured = $500,000
Therefore, you would be self-insured for 50% of the full value

If the amount of insurance claim = $100,000

Amount payable by the insurer as a result of the application of the
‘Average’/’Co-Insurance’ clause (ie. 50%) = $50,000
 Double insurance
• Double insurance arises where the same
party is insured with two or more insurers
in respect of the same interest on the
same subject matter against the same risk
and for the same period of time.
• Each insurance policy will become void if
the insured fails to notify the insurer of
the existence of the other insurance.
Double insurance - Example
In the homeowner example:
The owner bought two $250,000 policies on his home from different
companies, and a fire occurred that was covered under both policies,
the owner files a claim with one company.
That company will pay out the $250,000 to the owner.
Then, in accordance with the contribution principle, the company can
collect half of that amount, $125,000, from the other company.
Double insurance
[Link] insured: There can be no double insurance unless at the time of the claim, the same
person is entitled to benefit from each policy.
[Link] subject matter: It is not clear whether the policies must cover exactly the same property
in its entirety or whether covering a substantial part of the property would suffice. What is
important is that the subject matter in respect of which the claim is made is covered under both
policies.
[Link] risk: Double insurance will only arise if a substantial part of the same risk is covered by
both insurances.
Double insurance
4. Same interest: The policies must also cover the same interest. This is due to the fact that it is
not the subject-matter of the insurance as such which is covered by the policy but the insured’s
interest in it. There would therefore be no double insurance if two people who have different
interest in the subject matter insure their own interest.
5. Same period of time: Finally, the periods of time within each of the policies’ terms during
which the insured party is protected from the risk must be the same, or substantially the same. It
must also be during that period of time that the event giving rise to the claim occurs.